Accounts Receivable (AR) [PDF Inside]: Definition, Example, Turnover Ratio, Advantages, Disadvantages, & Account Payable

The word receivable refers to the payment not being realized. This means the company must have extended a credit line to its customers. 

Most businesses deliver the goods and services immediately to their customers, send an invoice, then get paid a few weeks later. Businesses keep a record of all the money their consumers owe them, using an account in their books called accounts receivable.

The total amount of accounts receivable granted to an individual customer, who is limited by a credit limit, which is set by the seller’s credit department, based on the past payment history with the seller and the financial condition of the buyer.

You can put accounts receivable under the ‘current assets’ section on your balance sheet. Accounts receivable are considered as an asset because they provide value to your company. 

Definition of Accounts Receivable

Accounts receivable (AR) is the balance of money due to a firm for goods or services provided, but not yet paid for by consumers. Accounts receivables are recorded on the balance sheet as a current asset.

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 Accounts Receivable (AR) is the payment that the company will take from its customers, who have purchased its goods & services on credit.

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Accounts receivable is the money due to a merchant from consumers who have not yet paid for their purchases. The amounts owed are stated on the balance sheets that are issued to consumers by the merchant.

Accounts Receivable Example

Example 1:

An example of accounts receivable includes an electric company that bills its clients after the clients received the electricity. The electric company records an account receivable for unpaid invoices, as it waits for its customers to pay their bills. 

Example 2:

On 1^st September, 2021, Max Enterprises sold goods worth 80,000 to National Traders, with a credit duration of 15 days. From 1^st September to the date the bill is paid, 80,000 will be considered as accounts receivables against National Traders account.

Suppose, on 10^th National Traders paid 45,000 to Max Enterprises. This will be deducted from National trader’s account. After adjustment, the overall accounts receivable will be 35,000.

What is the Accounts Receivable Turnover Ratio?

The accounts receivable turnover ratio shows you how fast your customers are at paying their bills.

We can calculate it by dividing total net sales by average accounts receivable.

Let’s take an imaginary company Educationleaves Inc.’s financials for the year 2020 as an example.

Let’s say that on the 1st January 2020, Educationleaves Inc. had total accounts receivable of $2,500. Let’s also say that at the end of 2020, i.e. Dec 31, its total accounts receivable was $1,500. It also had total net sales of $60,000 for 2020.

To get the average accounts receivable for Educationleaves Inc. for that year, we add the beginning and ending accounts receivable amounts and divide them by two;

$2,500 + $1,500 / 2 = $2,000

To calculate the accounts receivable turnover ratio, we then divide net sales that is $60,000 by average accounts receivable $2,000:

$60,000 / $2,000 = 30

This means Educationleaves Inc. has an accounts receivable turnover ratio of 30. The higher this ratio is, the faster your customers are paying you.

Thirty is a really good accounts receivable turnover ratio. 

Benefits or Advantages of Accounts Receivable

Here are some important advantages of accounts receivable:

Improve Your Cash Position

You have bills to pay. If you don’t get paid on time, you will surely run into dry spells when you owe more than you’re taking in. By concentrating on your accounts receivable, applying best practices, reminding consumers to pay, identifying invoices earlier, and making it easier for consumers to pay, you will have a very clear picture of your cash position.

Increase Control Over Cash

Understanding your cash position and enhancing accounts receivable performance is the key to improving and managing working capital. By managing working capital adequately, you have the insights you need to make important investment decisions such as capital equipment purchases, facility expansion, new employee appoints, and other investments to expand your business.

Easier to Meet Working Capital Requirement

Working Capital need can be met with ease as the business will not have to wait for consumers to pay off the accounts receivable. The receivable can be converted to cash as per the desire of the company.

Helps to Deal With Sudden Cash Requirement

Companies shouldn’t have to take high-interest loans in order to face sudden cash requirements. So accounts receivable financing helps a business to meet its requirement without issuing loans.

Stress-free Process

Account Receivable process is stress free. Sometimes it gets really difficult to recover money from customers. So as the stress of recovering money is being handled by the lender, so the company can pay attention to their main business processes.

Disadvantages of Accounts Receivable

There are several risks associated with carrying a large AR balance, including:

Uncollected debt

High accounts receivable that goes overdue for a long time is considered as bad debt. This condition arises when customers who purchase on credit go bankrupt or do not pay the invoice.

Cash flow deficiencies

Every business needs cash flow for its operations. Selling on credit may increase revenue and income, but it doesn’t offer any actual cash inflow. For the short term, it is acceptable, but in the long term, it can lead the company to run short on cash and have to take on other liabilities to fund operations.

Similar Term: Accounts Payable

Accounts payable are basically recorded upon receipt of an invoice based on the payment terms both parties agreed to when starting the transaction.

When a finance team gets a valid bill for goods and services, it is registered as a journal entry and posted to the general ledger as an expense. The balance sheet displays the total amount of accounts payable, but it does not list individual transactions.

Account payable departments process expense reports and invoices and for ensuring payments are made. A skilled account payable team keeps supplier relationships good by making sure vendor information is correct and up-to-date and bills are paid on time. The team can save the company money by taking full advantage of favorable payment terms and discounts. 

Accounts Receivable VS Accounts Payable

 Accounts payable and accounts receivable are two surfaces of the same coin. Whereas accounts payable represent money that your business owes to suppliers, accounts receivable represents money owed to your business by consumers.

Accounts receivable is regarded as a current asset, whereas accounts payable is regarded as a current liability. This is because accounts receivable will be converted to cash within a one-year period. On the other hand, accounts payable is considered being a current liability because it represents money that you owe to creditors. 

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