Accounts receivable

Accounts receivable refers to the outstanding amount of money that a business is owed by its customers for products or services sold on credit. These are classified as current assets on a company’s balance sheet because they are expected to be collected within a short period, typically within one year. Effective management of accounts receivable ensures strong cash flow and reduces the risk of bad debt.

Current Asset

A current asset is any resource owned by a company that is expected to be converted into cash or used up within one fiscal year. Accounts receivable falls into this category because payment from customers is usually expected within 30 to 90 days. Other examples of current assets include inventory, cash, and short-term investments.

Invoice

An invoice is a commercial document issued by a seller to a buyer, itemizing the products or services provided, the amount due, and the payment terms. Invoices serve as a formal request for payment and are the foundation for recording accounts receivable. They often include essential information such as invoice number, due date, and tax details.

Credit Terms

Credit terms define the conditions under which a buyer is expected to pay an invoice. These terms typically include the length of the credit period, any early payment discounts, and penalties for late payment. For example, “Net 30” means the buyer must pay within 30 days of the invoice date. Credit terms influence the timing of cash inflows and are a critical part of credit risk management.

Trade Receivables

Trade receivables are a subset of accounts receivable that arise directly from the sale of goods or services in the ordinary course of business. They reflect the amounts due from customers who purchased on credit. The term is often used interchangeably with accounts receivable, especially in manufacturing and retail sectors.

Cash Flow

Cash flow refers to the movement of money into and out of a business. Accounts receivable directly affect cash flow, as delays in collection can lead to cash shortages and hinder a company’s ability to meet its own obligations. A company with efficient accounts receivable processes enjoys more predictable and stable cash flow.

Accounts Payable

Accounts payable is the amount of money a company owes to its suppliers or vendors for goods and services received on credit. It is recorded as a current liability on the balance sheet. While accounts receivable represents incoming money, accounts payable represents outgoing payments. The two work together to determine a company’s working capital position.

Bad Debt

Bad debt occurs when a customer fails to pay an outstanding invoice, making it unlikely that the business will recover the amount owed. This is usually written off as a loss and reflects poorly on the company’s accounts receivable management. Businesses often create an allowance for doubtful accounts to anticipate potential bad debts.

Accounts Receivable Turnover Ratio

The accounts receivable turnover ratio measures how efficiently a company collects its receivables over a given period. It is calculated by dividing net credit sales by the average accounts receivable. A high ratio indicates that the company collects its debts quickly, improving liquidity, while a low ratio suggests inefficiencies or potential collection issues.

Days Sales Outstanding (DSO)

Days Sales Outstanding is a key performance indicator that measures the average number of days it takes a business to collect payment after a sale has been made. It is calculated using the formula:
DSO = (Accounts Receivable ÷ Total Credit Sales) × Number of Days
Lower DSO values generally signify better performance and faster cash collection cycles.

Cash Conversion Cycle (CCC)

The cash conversion cycle represents the time it takes for a company to convert its investments in inventory and other inputs into cash received from sales. It incorporates three components: the inventory conversion period, the accounts receivable collection period (DSO), and the accounts payable deferral period. A shorter CCC means the business recovers its cash investment quickly, enhancing liquidity.

Receivables Financing

Receivables financing is a financial strategy in which a company sells or pledges its accounts receivable to a third-party financier to receive immediate cash. This can be done through factoring or invoice discounting. It helps businesses improve their cash flow without waiting for customer payments, allowing them to reinvest in operations or reduce liabilities.

Early Payment Discount

An early payment discount is a financial incentive offered by the seller to encourage the buyer to pay an invoice before the due date. A typical format might be “2/10, Net 30,” meaning the buyer can take a 2% discount if they pay within 10 days, otherwise the full amount is due in 30 days. These discounts can help accelerate cash inflows and reduce the risk of payment delays.

Working Capital

Working capital is the difference between a company’s current assets and current liabilities. It is a measure of operational liquidity and short-term financial health. Accounts receivable is a critical component of working capital. Delays in receivable collections can strain working capital and hinder day-to-day operations.

Collections Process

The collections process refers to the series of activities a company undertakes to pursue payment from customers with outstanding invoices. This includes sending payment reminders, making follow-up calls, escalating overdue accounts to collections agencies, and possibly initiating legal action. A strong collections process minimizes bad debt and maximizes cash inflow.

Allowance for Doubtful Accounts

This is a contra-asset account that reflects the estimated portion of accounts receivable that may not be collected. It ensures that financial statements are not overly optimistic by recognizing potential losses ahead of time. This allowance is based on historical trends and current economic conditions.

Net Credit Sales

Net credit sales are the total revenue from sales made on credit, excluding any returns or discounts. This figure is used in several receivables performance metrics, such as the accounts receivable turnover ratio. It reflects the true amount of credit exposure a business has in a given period.

Factoring

Factoring is a specific type of receivables financing where a business sells its invoices to a third-party factor at a discount. The factor then assumes responsibility for collecting payment from the customer. This provides immediate liquidity, though at a cost, and can be especially useful for small or growing businesses.