Account receivable is a very important part of the financial statement of a company. It signifies the total amount of money that is owed to the company. This information can be used to analyze and evaluate the performance of the company.
Topics Discussed in This Article:
- Meaning of Account Receivable
- Examples of Account Receivable
- What is Account Receivable Turnover Ratio
- Benefits of Account Receivable
- Disadvantages of Account Receivable
- How Account Receivables are Managed
Account receivables are a measure of the total amount of money that is owed to a company. It is important to study about account receivables because it is one of the most important financial metrics for a company.
If there are more accounts receivable than cash, then it could mean that the company might not be able to pay off their debt in time.
Meaning of Account Receivable
the word receivable refers to the payment not being completed .This means the company must have extended a credit line to its customers. Most businesses sell to their customers on credit that is they deliver the goods and services, immediately send an invoice then get paid a few weeks later.
Businesses and companies keep record of all the money that their customers owe them by using an account in their books which is called accounts receivable. The total amount of accounts receivable allowed to an individual customer is typically limited by a credit limit which is set by the seller’s credit department based on the finances of the customers ( buyer ) and its past payment history with the seller. You can locate accounts receivable under the current asset section on your balance sheet.
Example of Account Receivable:
- An example of accounts receivable includes an xyz company that bills its clients after the clients received the goods or service. The xyz company records an account receivable for unpaid invoices as it waits for its customers to pay their bills.
Accounts receivables are treated as an asset for a company because they provide value to a company. It is usually a record of a company’s accounts payable, or the money owed by the company’s customers.
What is Account Receivable Turnover Ratio
Now let’s discuss about what is the accounts receivable turnover ratio. The accounts receivable turnover ratio is used to know how fast your customers are at paying their bills. To calculate it, we divide total net sales by average accounts receivable.
Let’s use an imaginary company xyz Incorporated’s financials for the year2020. As an example let’s say that on the January 1 of 2020xyz incorporated had total accounts receivable of $2500. Let’s also say that at the end of 2020i.e.December 31, it’s total accounts receivable was $1500. It also had total net sales oof$60,000for 2020.
- Now, to get the average accounts receivable for xyz incorporated for that year 2020, we add the beginning and ending accounts receivable amounts and divide them by two.
- To calculate the accounts receivable turnover ratio, we then divide net sales that is sixty thousand dollars by average accounts receivable i.e. two thousand dollars.
This means xyz incorporated has an accounts receivable turnover ratio of30. The higher this ratio is the faster your customers are paying you. 30 is a really good accounts receivable turnover ratio.
Benefits of Account Receivable
Allowing more credit to customers can expand the number of potential customers for a business resulting in an increased market share, but if some of them are paying you late or aren’t paying at all, selling to them could hurt your business.
5 Benefits of Account Receivable are:
1) Helps you plan your cash flow:
2) Helps you understand how much money your business owes its customers and when it will be paid:
3) Provides a snapshot of the health of the company:
4) Allows you to compare performance to previous periods:
5) Provides valuable insight into clientele and their payment patterns.
Late payments from customers are one of the top reasons why companies get into cash flow problems. Account receivable turnover ratio is one of the best ways to keep track of late payments and make sure they aren’t getting out of hand.
Disadvantages of Account Receivable
There are several risks associated with carrying a large accounts receivable balance including uncollected debt. High accounts receivable that goes uncollected for a long time is written off as bad debt. This condition occurs when customers who purchase on credit go bankrupt or do not pay the invoice.
5 Disadvantages of Account Receivable are:
1. Unsecured credit: The company will have to rely on the customer’s promise to pay the debt and this is not a very secure way of doing business.
2. Non-payment: If the customer doesn’t pay, it is hard for the company to get the money back and this can lead to bankruptcy.
3. Bad credit: Even if customers have good intentions of paying, they might not be able to do so because of their bad credit history and this will lead to a loss for the company as well as for themselves.
4. Low cash flow: This could result in bankruptcy because it will be difficult for companies that don’t collect enough money from their customers at regular intervals, which could happen because people are unable to pay or simply refuse to do so.
5. Collection costs: If a company has already tried everything possible but still hasn’t been able to collect money from its customers, then it will need someone else who specializes in collecting.
How Account Receivables are Managed?
The management of a company’s account receivables can be done in two ways:
1) Retaining the receivables and managing them internally,
2) Selling the receivables to another party.
Retaining the receivables and managing them internally has its own benefits. The company retains control over its inventory, which may have a higher resale value than selling to another party.
Also, they don’t need to worry about any risks that may come with selling their debtors to another party. However, there are some disadvantages as well- such as needing more financing from banks or other parties, or having to deal with the administrative costs of collecting debts on their own.
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