Cash may be king for most businesses, but credit is a fact of life. Most businesses offer their customers time to pay for goods and services. When companies do business using credit, accounts payable (AP) and accounts receivable (AR) need to be managed properly.
Let’s explore what AP and AR are and why they’re key to keeping cash flowing out of and into your business.
What Is Accounts Receivable?
When a business sells goods or services to a customer on credit, an account receivable entry is created on the seller’s books. The AR entry reflects the amount owed by the customer in accordance with the seller’s billing terms.
For example, when Woody’s Building Supply sold lumber to Joe Contractor and sent him an invoice to pay in 30 days, Woody recorded an account receivable from Joe. When Joe ultimately pays Woody, the account receivable will be removed from Woody’s books and replaced by cash.
More formally, AR represents non-written promises of a purchaser to pay for goods and services. AR is considered a current asset on the seller’s balance sheet because it has economic value that is expected to be collected and converted to cash within a short time, typically within the year.
The faster AR is collected, the quicker money gets into the seller’s hands and the stronger the business’s cash inflows.
Long-term assets generate value for a business over many years, such as buildings, furniture, and patents. For bookkeeping purposes, the value of AR increases by debits – meaning any time the business “loans” money to a customer by giving them time to pay for a purchase – and decreases by credits, meaning when a customer pays the bill.
The details of each transaction that generates an AR entry are typically found on the bill or invoice that the seller gives to the buyer. That invoice sets the payment terms for the buyer, such as payable in 30, 60, or 90 days. The AR is said to be “open” until the invoice is paid by the customer and is “closed” when the customer pays.
The AR journal, or subledger, lists all of a company’s open ARs from all customers. "Trade receivables" is a specific term for AR entries that arise from the normal course of business, in contrast to nontrade receivables, which arise from supplemental activity.
How Accounts Receivable Affects Cash Flow
When a company sells goods and services it expects to be paid.
AR are debts owed to the seller for goods and services that have already been delivered and for which the seller likely has previously incurred costs to produce.
The longer an AR entry stays open – called “aging” – the longer a seller is without cash inflow. As a result, when AR balances increase, it is considered a “use of cash” because the business must cover the costs before receiving payments from customers. This can be problematic since the seller needs cash to meet its core obligations, such as payroll and raw material purchasing.
Therefore, the faster AR is collected, the quicker cash gets into the seller’s hands and the stronger the business’s cash inflows.
It's generally known that the longer an AR entry ages, the less likely it will be collected. To manage that, accountants usually allot an “allowance” for doubtful accounts that is an estimate of the amount of AR that may not be collected. Allowances reduce the AR balance on a business’s balance sheet. When a specific invoice is deemed to be uncollectable, it is said to be “written off” and is eliminated from the AR balance.
Tips for Accounts Receivable Management
Extending short-term credit to customers can be a helpful way to increase sales and is considered a necessary business norm. It’s important to manage AR in a way that sets a seller up to maximize payment.
Here are five best practices to get you started:
- Consider the creditworthiness of customers before extending credit.
- Stick to payment terms that make sense for your business.
- Monitor metrics, such as AR aging, days sales outstanding (DSO), and collections per collection agent.
- Offer customers multiple ways to pay, such as credit cards, digital wallets, and bank transfers.
- Give customers small discounts for early payments.
What Is Accounts Payable?
Accounts payable is the balance a business owes to others from the purchase of goods or services on credit. AP reflects the amount to be paid out in the future, recorded on the purchaser’s books.
For example, when Joe Contractor bought the lumber on credit, an AP entry was recorded in Joe’s books. When Joe pays Woody’s invoice, the AP will be removed.
Since AP is a debt caused by the time lag between the receipt of goods or services and when they need to be paid, it is considered a liability on the buyer’s books. Because most AP is expected to be paid in a short period of time, as dictated by the seller’s invoice, it is categorized as a short-term or current liability on the buyer’s balance sheet.
Being the mirror image of AR, the value of AP increases with credits and decreases with debits in a company’s books. In other words, increases are caused by additional purchases and decreases result from paying the invoices.
Similar to AR, AP is considered “open” until the invoice is paid and is then “closed” once payment is made.
"Trade payables" arise from the normal course of business, in contrast to nontrade payables, which arise from other commitments like rent or taxes. The AP subledger is a list of all the open APs to each supplier. Obligations related to payroll or long-term loans are not included in AP.
How Accounts Payable Affects Cash Flow
Buying on credit helps businesses receive needed goods and services from suppliers quickly, which keeps their operations running smoothly. As with all credit buying, payment must be made eventually, although most businesses are inclined to hold their cash as long as possible.
When AP balances accumulate, it is said to be a “source of cash,” since a company is holding its cash while benefiting from purchases at the same time. When a company pays down its AP, it is called a “use of cash.”
Consequently, managing the timing of future cash outflows – not paying too soon yet not incurring late fees – is a primary AP goal. Running up balances or frequently making delinquent payments can hurt supplier relationships or even cut off access to needed supplies.
Tips for Accounts Payable Management
Taking advantage of extended payment terms from suppliers can be a helpful way to “finance” purchases and hold on to precious cash. However, building up large AP balances can be cause trouble when applying for loans, incur additional costs from late fees, and strain your supply chain.
Here are four best practices for managing AP:
- Monitor days payable outstanding (DPO), which shows how long your business takes to pay invoices, so you can strike a balance between retaining cash and maintaining supplier relationships.
- Track how often the business captures early pay discounts, which help reduce costs and increase profitability.
- Invest in automation and training because mistakes can be costly.
- Enhance internal controls, such as the approval process for new vendors and requiring invoices to be matched with purchase orders and/or shipping documents. The AP process is a place where fraud often occurs.
The Takeaway
Both accounts receivable and accounts payable result from business transactions made on credit rather than cash. They mirror each other – one company’s AR is another company’s AP.
A seller’s AR is the amount it is owed by customers for sales and represents future cash inflows. A common AR issue is the speed of collection.
A buyer’s AP is the amount it owes to others for its purchases. It represents future cash outflows for the purchaser, so adequate funding and appropriate timing are key.
Most companies have both AR and AP and need to carefully balance both in order to optimize cash flow.
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