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Accounts payable (AP) and accounts receivable (AR) each represent competing sides of your business's cash flow. AP is the money you owe to suppliers while AR is the money owed to you by your customers.
Understanding the difference between the two and how to track them could help you better gauge liquidity, manage working capital, and make informed decisions that could directly impact your business's financial health.
Read on to learn how to compare accounts payable vs. accounts receivable, and where they may have the potential to affect your business the most.
Key takeaways:
- Accounts payable is the money a business owes to its suppliers and creditors.
- Accounts receivable represents the money owed to a business by its customers.
- Both accounts payable and accounts receivable may factor into business decision-making, from developing a working budget to securing financing to fund growth or fill cash-flow gaps.
What Is Accounts Receivable?
Accounts receivable is the money a business is owed by customers for goods or services already delivered. When measuring cash-flow health, AR represents a current asset on the balance sheet. Why not a liability? Accounts receivable have economic value that you may collect and convert to cash within a reasonable time frame.
Tracking accounts receivable may offer insight into:
- How quickly (or slowly) customers pay you
- How effectively your business collects outstanding payments
- Your current liquidity and expected future cash flow
- The effectiveness of your credit and collection policies
Accounts receivable may also be useful in developing revenue forecasts and appropriate strategies to counter periods of slower cash flow. Those strategies could include restructuring a customer's payment terms to help avoid default, securing short-term financing, or reducing expenditures temporarily to maintain liquidity. Understanding how to navigate AR could help position your business for success.
How Accounts Receivable Could Affect Cash Flow
When you sell goods or services, you expect to be paid. The longer an AR entry stays open on the books, the longer you have to go without that cash inflow. Delayed payments could put more pressure on you to cover operational costs until invoices are paid. As liquidity shrinks, you may have to defer paying certain expenses or seek short-term financing to get the necessary capital you need to cover them.
The faster AR is collected, the sooner your cash-flow health could begin to strengthen. As an accounts receivable item ages, the likelihood that it will be collected declines. Eventually, an unpaid AR entry may need to be removed from the books, at which point it becomes a bad debt. Monitoring some key metrics could help you avoid that scenario:
- AR turnover: Accounts receivable turnover is your total net sales divided by your average accounts receivable. Turnover ratio measures how effectively you collect payments from customers. A higher ratio may suggest better cash flow.
- Aging: Aging refers to how long an AR entry remains open. Running an aging report on accounts receivable could help you to see how long each item has been open to gauge the strength of your collection practices, as well as individual customer credit risk.
Here's an example of how to use AR turnover to understand cash flow. Assume you have $2.5 million in net sales annually and a $415,000 average AR entry. Your AR ratio is 6, which may indicate that you collect your entire receivables balance six times annually. That works out to every two months or 60 days.
That may not be a problem if you issue invoices with net-60 terms. However, if you expect customers to pay on a net-30 or net-45 basis, your business may experience more cash-flow delays. Taking corrective action to help encourage timely payment, such as implementing a late fee policy, may improve your AR turnover ratio and may help support cash-flow management.
Tips for Accounts Receivable Management
Managing accounts payable vs. accounts receivable could take planning and a commitment to following through on the strategies you implement. The goal is to manage AR in a way that could help set you up to increase the potential for payment.
Here are five tips that could get you started:
Assess customer credit: Before extending credit to customers, consider reviewing their financial stability. Vetting customers this way may help minimize potential default risks and may help to support stronger relationships from the start.
Set clear payment terms: A written credit and collections policy could help clearly communicate your expectations to customers. When drafting your policy, consider the terms that are most appropriate for your business, and if you plan to include penalties for late or non-payment, try to spell them out transparently.
Invoice promptly: A timely, detailed invoice may help encourage customers to pay as soon as goods or services are received. You may also consider offering a small discount for customers who make early payments.
Monitor aging reports: Routinely running aging reports could help identify invoices that are past their due date or items that are on the verge of falling past due. That way, you could gain a better idea of which customers to contact first with a payment reminder.
Follow up consistently: Some customers may require more prodding than others to pay outstanding invoices. As you draft your collection policy, you may develop a timeline for how often you'll follow up and how long you'll give customers to pay before you consider an AR balance to be uncollectible.
Automation tools could help you manage accounts receivable more effectively. For example, your accounting software may include tools that automatically generate aging reports or calculate AR turnover, so you may more easily pinpoint potential trouble spots in your cash flow.
What Is Accounts Payable?
Accounts payable is money a business owes to vendors or suppliers for goods and services already received. AP reflects the amount to be paid out in the future, which may be used to help predict your cash flow.
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's considered a liability on the books. Because most AP is expected to be paid in a short period of time, it may be categorized as a short-term or current liability on the buyer’s balance sheet.
In terms of how that relates to cash flow, accounts payable may help you:
- Manage short-term financial obligations for your business
- Anticipate outflows and their timing
- Plan and schedule payments to coincide with the timing of AR inflows
Having insight into your accounts payable may also be useful in negotiating more favorable payment terms with vendors and helping to improve the relationship you have with your suppliers. For example, if your records indicate that you've consistently paid a vendor's invoices early the last 12 months in a row, you may be able to leverage that to get a discount.
Tracking AP may also help you better understand your business expenditures. That could help inform how you approach budgeting, which may include reducing or eliminating expenses to help manage cash flow. Accounts payable may also help with forecasting and determining when the timing may be right to pursue growth projects, based on how cash is moving in and out of the business.
How Accounts Payable Could Affect Cash Flow
Accounts payable is the money your business has to pay to someone else. Buying on credit may help businesses receive needed goods and services from suppliers, which keeps operations running smoothly. But eventually, the invoice comes due.
Managing the timing of future cash outflows, meaning not paying too soon but not delaying payment so that you incur late fees, may be a primary AP goal for many business owners. Why? Because doing so could help preserve liquidity as you await payment from customers, which in turn could help support day-to-day operations and help reduce the need for short-term financing.
Running up balances or frequently making delinquent payments, meanwhile, could hurt supplier relationships or even potentially cut off access to needed supplies. For that reason, it may be helpful to:
- Monitor payment terms across all vendors and suppliers to track payment due dates
- Maintain transparent communication with vendors and suppliers surrounding your ability to pay
- Track accounts payable turnover, which measures your business's liquidity
To calculate AP turnover, divide net credit purchases by your average accounts payable. A high turnover ratio could indicate that your business is prompt in paying supplier and vendor invoices, while a lower ratio may suggest slower payment. Lower doesn't necessarily mean bad; it could signal cash-flow problems, but it may also indicate that your supplier has extended more favorable credit terms to your business.
Tips for Accounts Payable Management
Taking advantage of extended payment terms from suppliers could be a helpful way to help pay for purchases and hold on to precious cash. However, building up large AP balances could be a factor when applying for loans, incur additional costs from late fees, and strain your supply chain. Developing management strategies for accounts payable vs. accounts receivable could benefit your business in both the short and long-term.
Here are four best practices to consider for managing AP:
Negotiate clear payment terms: As you establish credit with vendors and suppliers, consider reviewing the payment terms being offered to determine how well they align with your business cash flow.
Organize invoices efficiently: Missing invoices could lead to challenges with vendors and suppliers if you pay late. Developing an organizational system, either inside your accounting software, using a spreadsheet, or on paper, may help you keep tabs on all of your AP items.
Time payments strategically: If you're tracking AR regularly, that may make it easier to determine when to time payments to vendors and suppliers. You may find it helpful to monitor days payable outstanding (which shows how long your business takes to pay invoices) so you may strike a balance between retaining cash and maintaining supplier relationships.
Automate: Investing in automation could help you to avoid potentially costly mistakes, such as unpaid invoices or incorrect payment amounts, both of which could sour vendor relationships.
Disciplined payables management could help support budgeting and operational planning. It could also help take the guesswork about when to fund a new project or reduce worries about late fees, because you may see how much cash you have available now and what's in the forecast.
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