Accounts Receivable & Payable

2.1 Accounting for Purchases—Discussion Guide

Performance Indicator: Account for purchases (e.g., purchase requisitions, purchase orders, invoices, vouchers, etc.)

THINK ABOUT IT

If a company expects to stay in business, it must account for all its purchases.

• Businesses use a variety of documents and processes to accurately and efficiently track, record, control, and distribute only legitimate payments to vendors and suppliers.

KEY CONCEPTS

Slide #1 Importance of Accounting for Purchases

• It is vitally important businesses accurately and completely account for all purchases.

  • Within businesses, this department is called accounts payable.

  • The accounts payable function is responsible for recording, controlling, and disbursing payments to vendors.

  • It is essential businesses issue payments for only those bills that are both accurate and legitimate, which contributes to the importance of the accounts payable department.

  • Accounts payable involves almost all payments a company issues, excluding payroll.

• It’s helpful to think of accounts payable as short-term “IOUs” your business issues to other businesses.

  • Vendors and suppliers will provide products and services to your business, which you purchase on credit with the promise to pay at a later date.

  • Therefore, it is essential to properly record all purchases.

  • Tracking purchases and issuing correct payments is your responsibility as a business owner.

• Businesses must ensure they compile accurate financial statements in the most efficient and effective manner possible.

  • The success of their accounts payable process impacts the business’s credit and cash flow.

  • Properly accounting for purchases enables companies to manage their cash position.

  • Keeping track of all money and bills owed to other businesses helps companies comprehend their financial health by detailing how much money is available, both to pay bills and to use to do business.

  • This supports short and long term business planning.

• Properly accounting for purchases also affects companies’ relationships with vendors and suppliers.

  • If a business does not pay its bills on time, this will negatively impact those necessary relationships.

  • It will incur late fees for delayed or missed payments, which can be costly, and repeated late payments can permanently damage those relationships.

  • Accurately tracking its accounts payable schedule and paying bills on time in the correct amounts helps companies build connection by showing they are responsible, trustworthy parties with which to do business.

Slide #2 How Businesses Account for Purchases

• Businesses account for purchases with a few different documents:

  • Purchase requisitions, which businesses use to request the purchase of goods or services for the company.

    • This document starts the purchasing process, although not all businesses use purchase requisitions.

    • Some businesses only use these documents for purchases that exceed a certain dollar amount.

    • Details include item descriptions and quantities, vendors, prices, and name of purchaser.

    • These documents are mainly used to ask permission, and they are not legally binding.

  • Purchase orders (or POs), which outline the precise details of an actual purchase from a vendor.

    • This document includes the PO number, description of items, prices, shipping method, date needed, and other important information.

    • It is used by the vendor as a set of instructions to fulfil the order, and it externally initiates the purchasing process.

    • Once both the buying and selling companies agree and sign, the PO becomes a legally binding document.

    • It is important to note that POs are not prompts for payment.

  • Receiving reports, which are completed by the company receiving the items.

    • This internal document indicates the quantity and description of goods it receives.

    • It typically includes the date and time the order was received, name of the shipping company, and condition of items.

    • This document is used as evidence of receipt in the three-way match control process.

  • Invoices, which itemize the transaction between buyer and seller.

    • It includes the invoice number, contact information, dates, details and costs of each item, tax and shipping charges, payment terms and conditions, and total owed.

    • The total due represents an account payable for the buyer and an account receivable for the seller.

  • Vouchers, which serve as a cover sheet for the compiled purchase order, receiving report, vendor’s invoice, and other important paperwork.

    • Businesses use this internally to organize all documents and approvals prior to paying an invoice; it is a document that “vouches for” a completed approval process.

    • After the supplier is paid, the voucher is marked “paid,” a copy of the check is included, then it’s moved to a paid voucher/invoice file.

Slide #3 Techniques for Accounting for Purchases

• Businesses account for purchases using a three-way match.

  • This technique assures the validity and accuracy of all payments issued from accounts payable.

  • Businesses compare the details of the receiving report to the purchase order.

  • After this information is reconciled, both documents are compared to the vendor invoice.

  • The purchase order details what the business ordered and the cost, the receiving report details what the business actually received, and the invoice details how the vendor billed the business.

  • When all three documents match, the invoice will then be scheduled for payment.

  • Some businesses decide to use two-way match by matching just the PO and invoice.

2.2 Processing Accounts Payable—Discussion Guide

Performance Indicator: Process accounts payable (e.g., maintain vendor file, post to ledger, process invoices and checks)

THINK ABOUT IT

Accounts payable is one of the most important business functions: it directly impacts a company’s credit rating, cash flows, and supplier relations.

• The accounts payable department is responsible for verifying and paying only those bills that are legitimate and accurate.

• Read on to learn how businesses process and record accounts payable.

KEY CONCEPTS

Slide #1 Importance of Accounts Payable

• The accounts payable department plays the vital role of managing and verifying accuracy of all payments to suppliers and vendors.

  • An efficient, accurate accounts payable system directly impacts the success of the company, no matter the industry, size, or volume of business.

  • A well-run accounts payable department that pays only accurate and legitimate bills within the agreed upon timeframe boosts the company’s credit rating, balances the business’s cash flows, and ensures the business maintains positive supplier and vendor relationships.

• Supplier relations are especially important because they directly affect the business’s flow of products and services; if a business consistently makes late payments, it will incur fees and damage those relationships, leading to a poor reputation and the risk of poor financial standing.

• Accounts payable is tasked with locating any potential discounts or opportunities to save money, whether through early repayment schedules or optimizing the business’s cash flow.

  • Accounts payable is also responsible for implementing internal controls to protect company assets, prevent fraudulent charges, and ensure accurate accounting.

Slide #2 Cash Flow and Accounts Payable

• Accounts payable is a short-term liability that plays a considerable role in a company’s cash flow.

  • As a result of assorted repayment timeframes (e.g., 30, 60, 90, 120 days), businesses can manipulate their cash flow to accomplish certain objectives.

  • If, for example, a business extends its average payable period from 18 days to 30 days, it frees up 12 extra days of cash outflows that business can then use to lower debt or put toward other purchases.

  • Businesses can pay bills any date up to their payment date, so they can take advantage of this flexibility to optimize the company’s cash flow.

  • As long as the business pays its bills on time, it has the freedom to adjust payment schedules to meet its needs.

  • Companies should aim to balance the tasks of adjusting their payment schedule with taking advantage of discounts for early repayments.

  • Careful planning within accounts payable helps businesses make better financial decisions.

Slide #3 Accounts Payable Controls

• Businesses should implement various internal controls to protect the company’s cash and assets.

  • These controls serve to prevent paying invoices twice and avoid paying fraudulent or incorrect invoices.

  • Larger companies often separate employees’ responsibilities to help prevent fraud: each person fulfills a specific task from preparing POs to performing the three-way match to paying vendors.

  • Companies are encouraged to spot check their processes to verify successful controls; it’s also recommended for companies to hire professionals to improve their controls.

• Other ways to mitigate risks include three broad categories:

  • Commitment to pay controls: requiring a purchase requisition form, electronically searching for duplicate invoice numbers, implementing three-way match, etc.

  • Data entry controls: using consistent invoice numbering and eliminating leading zeros and dashes, etc.

  • Payment controls: requiring manual check signing, storing checks in a secure location, using additional signers if the amount is sizeable, etc.

Slide #4 Accounts Payable Process/Workflow

• The accounts payable process is as follows:

  • Receive the purchase order (PO):

    • The PO initiates the purchasing process; create a new file.

  • Process the receiving report:

    • After the purchase is received, record the date, quantity, and quality of all items.

    • Move into the vendor file, which is the catalogue of all business suppliers.

  • Process the invoice:

    • The vendor invoice requests payment for purchases.

    • Move to the file.

    • Credit the accounts payable account.

    • Debit the account that represents the expense.

  • Perform a three-way match:

    • Verify accuracy by comparing all details on the PO, receiving report, and vendor invoice.

    • If there are discrepancies, send to the buyer to correct issues and verify new paperwork.

    • The invoice is processed only after confirming all terms match.

  • Prepare the voucher:

    • The voucher is a cover sheet that “vouches” for the completeness of all supporting materials.

    • It certifies all documents and payments have been authorized.

  • Schedule payment:

    • Schedule payments on or before due dates to preserve relationships.

    • Debit the accounts payable account.

    • Credit a money (e.g., checking or cash) account.

  • Update all records:

    • Stamp all documents “PAID,” make copies of the final check, close the vendor ledger account, move all documents to Paid Voucher/Invoice File, and verify accuracy of entry in the accounting books or software.

2.3 Impact of Accounts Payable—Discussion Guide

Performance Indicator: Analyze the impact of accounts payable schedules on working capital

THINK ABOUT IT

Businesses must spend money to make money.

• For example, the materials that a business relies on to make its products don’t come free – companies must pay for them!

• Often, businesses pay for needed items like inventory and utilities on credit.

• To manage the debts they incur, businesses use accounts payable.

• Read on to learn more about the impact of accounts payable on working capital.

KEY CONCEPTS

Slide #1 The Impact of Accounts Payable Turnover

• Accounts payable (AP) is all monies owed by the business to others, such as vendors or suppliers.

  • You can think of AP as a kind of “IOU,” because it represents short-term debt that must be paid off within a given period to the creditor.

• Accounts payable turnover measures the number of times a company pays off its accounts payable during a period.

  • Investors and creditors will often look at a company’s AP turnover to see how efficiently it pays back its short-term debts.

• Companies certainly want to pay back their debts within the agreed upon time period.

• Otherwise, there can be serious consequences for failing to keep up with debt obligations.

• However, companies don’t always choose to pay off their debts as soon as possible – instead, they often wait to pay back their creditors until closer to the debt’s due date.

• By delaying the payment, management can keep more working capital (e.g., cash) on hand for other endeavors.

• Effectively managing accounts payable is a kind of balancing act: Leadership wants to pay off its debts quickly, but without missing opportunities for other investments.

• In this way, AP turnover can have a great deal of impact on the cash flow of a business at any given time.

Slide #2 The Impact of Days Payable Outstanding

• Days payable outstanding (DPO) measures the average time (in days) it takes a company to pay back its debts.

• Similar to AP turnover, this financial ratio indicates how well a business manages its cash flows.

  • The higher the DPO, the longer it takes a business to pay its bills.

    • A company with a high DPO can use available capital for other investments, but it must not delay too much.

    • Otherwise, it could jeopardize relationships with its creditors and indicate an inability to pay.

  • A low DPO generally indicates that the company is not using its available capital most efficiently, because any money received immediately goes to bill payment (rather than business investments).

• Like AP turnover, DPO greatly impacts working capital and requires delicate balance.

Slide #3 The Impact of Cash Conversion Cycle

• The cash conversion cycle (CCC) is a ratio that refers to the number of days between a company’s payment for raw materials and reception of cash from selling the products made from those raw materials.

• It helps evaluate company efficiency by following the lifecycle of cash, from its start as an investment to its end as a return.

• This metric is expressed in number of days, and it accounts for the time needed to sell inventory, collect receivables, and pay bills.

• The CCC is a way to evaluate how well leadership is managing working capital.

• Generally, companies try to avoid a longer CCC, as this indicates it takes longer for a business to generate cash.

• If a company pays its debts too quickly (i.e., it has a low DPO), it lengthens the CCC.

• A shorter CCC indicates a healthy company because money in hand can be used to re-invest in the business.

Slide #4 The Impact of Adjusting Payment Terms

• Terms are specific points that reveal each party’s expectations and responsibilities in a negotiation agreement.

  • More specifically, payment terms lay out the rules for how and when a payment must be made.

• When businesses purchase items on credit, they agree to payment terms.

• There are a few different types of payment terms:

  • “Net terms” (which dictate when the full payment is due)

  • “End of month terms” (which declare how many days after the end of the month a payer must issue payment)

  • “Discount terms” (which provide a discount for early payment of debt)

• Any adjustment of payment terms impacts a business’s working capital.

  • For example, if payment terms are shortened, then the company has less time to pay back its debt within the agreed-upon time period.

  • Thus, the company has decreased opportunity to use that capital for its own investment.

  • Alternatively, if payment terms are lengthened, the company has more time to pay, which means it can be more strategic with any capital it has until it approaches the debt’s due date.

Slide #5 Impact Analysis Techniques

• As noted, the efficient management of accounts payable can be a delicate balancing act.

  • Pay off debt too early, and the business loses growth opportunities (and might signal potential problems for investors).

  • Pay off debt too late, however, and companies risk breaching payment agreements and incurring penalties.

• In addition to analyzing AP turnover, DPO, and CCC, investors might also examine any discounts taken and late payment fees incurred to evaluate how well a company navigates its account payable schedule and its subsequent impact on working capital.

2.4 Accounting for Long-Term Liabilities—Discussion Guide

Performance Indicator: Account for long-term liabilities (e.g., bonds payable, notes payable, leases, etc.)

THINK ABOUT IT

When you’re running a business, you will likely have to make large purchases to keep the business going.

• You might need to buy a piece of equipment or even an entirely new office space.

• These large purchases often require going into debt to acquire them, and they can take more than a year to pay off.

• Such purchases are called long-term liabilities, which you’ll learn more about below.

KEY CONCEPTS

Slide #1 Long-term liabilities are debts that are owed for more than one year.

• They are sometimes called noncurrent liabilities.

• A debt owed for less than a year is a current liability.

• Both long-term liabilities and current liabilities are listed on a balance sheet.

  • The balance sheet is a financial statement that captures the financial conditions of a business at a particular moment in time and includes all assets and liabilities.

• Long-term liabilities and current liabilities are listed separately on the balance sheet to make interpreting the information simpler, but also because long-term and short-term liabilities have different uses.

  • Long-term liabilities are often incurred when businesses purchase equipment, buildings, or other types of capital investment that are too expensive to purchase outright.

  • Businesses take on long-term debt in the hope of eventually turning that investment into an asset and profiting from it in the future.

  • Current liabilities are usually the costs taken on in the regular operation of the business.

  • If the current liabilities are too high, it’s unlikely a business would be able to stay active because it has taken on too much debt.

Slide #2 Common types of long-term liabilities that businesses may list on a balance sheet include bonds payable, notes payable, deferred taxes, and leases. Take a look at these common long-term liabilities below.

• Bonds payable.

  • Bonds payable are typically associated with corporations, hospitals, and governments that need to generate cash flow.

  • Such organizations may issue a bond, or debt.

  • Think of the bond as an IOU.

  • A buyer will purchase the bond with the agreement that the issuing organization will pay interest periodically, such as every six months, to the buyer.

  • The organization is obligated to pay back the full amount of the bond to the buyer at a specific date in the future.

  • That full amount is called the principal.

  • Bonds payable is normally listed as a long-term liability because bonds usually do not mature in one year.

• Notes payable.

  • Notes payable is used to account for money that needs to be paid back to a bank.

  • With notes payable, the issuing agency will provide money to the borrower, and the borrower agrees to pay back the sum at a certain date with interest.

  • If payments are listed within one year, the note payable would be listed as a current liability.

  • Interest payments within one year would also be a current liability.

  • If the due date is over one year, it is a long-term liability.

• Deferred taxes.

  • Deferred tax liabilities are taxes that are anticipated to be paid outside of one year.

  • A business would use deferred tax liability when it receives income inside one year, but the actual tax payment is not due within that period.

  • For example, a business may have sold its products and received income for that sale in 2021, but the income tax is not due until 2022.

  • The deferred tax liability is based on the expected tax rate for the upcoming tax year and recorded on the balance sheet.

• Leases.

  • Leases that are longer than one year need to be listed on the balance sheet.

  • The liability from a lease is recorded at the full amount on the balance sheet at the start of the lease.

  • The full amount recorded on the balance sheet on its initial date is called the right of use asset.

    • It indicates the full value of the lease at the time the asset is recorded.

Slide #3 When a liability is acquired, the first thing that needs to be determined is if the liability will last for more than one year.

• If yes, it is designated as a long-term liability.

• However, any payment made towards that newly acquired liability within one year is a current liability.

  • For example, your business might buy a piece of equipment for $12,000.

  • If you make a down payment of $2,000 to purchase the equipment, then the long-term liability is $10,000 and the retail value of the asset is $12,000.

  • You plan to pay $2,000 annually for five years.

  • The next year, the current liability for the equipment would be $2,000 and the long-term liability decreases to $8,000.

  • The third year, the current liability would again be $2,000 and the long-term liability would be $6,000, and so on.

2.5 Accounting for Sales—Discussion Guide

Performance Indicator: Account for sales (e.g., invoices, sales slips, etc.)

THINK ABOUT IT

What would happen if your local furniture store guessed the amount each customer owed them?

• They chose not to follow up with customers and assumed everyone would pay the correct amount at the right time.

• This store would quickly go out of business!

• Companies must accurately account for and collect all payments that are due from the sale of their goods and/or services.

KEY CONCEPTS

Slide #1 Importance of Accounting for Sales

• If a business hopes to stand any chance at being successful, it must accurately and efficiently account for the sales of all of its goods and/or services.

  • Within businesses, the department in charge of recording, controlling, and collecting payments due from sales is called accounts receivable.

  • Accounts receivable represents the money a business is owed, or should receive, from the products or services it delivered to customers.

  • Companies extend lines of credit to customers who cannot or will not pay for products or services in cash.

  • Businesses typically offer credit terms from 30 to 90 days for buyers to issue payment for the products or services they received.

  • This enables companies to increase both sales and customers.

  • Buyers can then purchase the items they need at the time they need them, instead of only purchasing when they have the cash on hand.

• It is crucial to properly track a company’s sales and payments.

  • Without consistent monitoring, a business could fail to remember to bill some of its customers.

  • The company could have no idea whether it had been paid the correct amount, or even if it had been paid at all.

  • If a business doesn’t accurately account for all of its sales, it could provide products or services for free, which directly influences the company’s value.

• The efficient tracking of and accounting for sales impacts a company’s profitability.

  • If the business regularly misses collecting payments, this limits its cash flow.

  • It also restricts the business’s ability to invest in other production and operating activities, including any time-sensitive opportunities.

  • Tracking sales is vital to ensuring the business gets paid promptly.

  • Businesses can accomplish this by communicating with customers on a regular basis, clearly documenting all purchases, and employing a solid internal process with detail-oriented accounts receivable staff.

  • Monitoring how often and proficiently a business gathers payments on time illustrates how effectively that business collects its debts.

Slide #2 How Businesses Account for Sales

• Businesses account for sales with a couple different documents:

  • Invoices, which companies send to the customer that owes money in exchange for products and/or services sold.

    • The invoice communicates to the customer the items and quantities purchased, taxes, balance owed, due date, and payment (or transaction) terms.

    • These transaction terms include details about late payment fees, interest after certain dates, and/or cash discounts.

    • The sales invoice signifies revenue the business has earned.

    • Invoices must clearly communicate payment information to the customer to ensure timely payment.

  • Sales receipts, which companies issue when the payment for products and/or services sold occurs as a single transaction.

    • Sales receipts are typically used when the company receives payment immediately, while invoices are used when the company receives payment later.

    • After the transaction, there isn’t any additional money owed.

    • Sales receipts are usually issued on the spot in paper- or digital-form and include information about and prices of the items sold, taxes, and the total amount due, but they don’t include payment terms.

Slide #3 Techniques for Accounting for Sales

• Businesses use accounts receivable aging schedules (or reports) to track all sales and payments.

  • These schedules display the company’s accounts receivables, organized by invoice due dates.

  • Aging schedules are customizable, with categories for customer names, then current (or under 30 days), 1-30 days past due, 30-60 days past due, 60-90 days past due, more than 90 days past due, and a final category totaling the amount paid against their bill.

  • In this way, companies track which customers are paying on schedule and which are behind and need contacted with reminders to pay.

• Companies can employ several techniques to encourage customers to pay on time.

  • Businesses should enforce well-defined credit guidelines, even if that means losing some customers in the interim, and they can establish interest payments for late payments.

  • Businesses can offer discounts for early payments, which often helps them get paid more quickly and reduces customer costs.

  • Companies should send regular reminders, often via email, to help customers pay on time.

• Aging schedules help companies identify potential cash-flow issues before they become catastrophic, and they enable businesses to refine their credit policies.

  • These schedules are particularly useful when measuring a company’s operational and fiscal performance.

  • Managers review aging schedules to help predict future cash flow and enhance working capital management.

  • Creditors also use aging schedules to determine whether to lend money to the company.

  • Accounts receivable aging schedules enable businesses to be proactive with their finances instead of reactive.

2.6 Processing Accounts Receivable—Discussion Guide

Performance Indicator: Process accounts receivable (e.g., post to ledger, process payment, process uncollectible account, etc.)

THINK ABOUT IT

Accounts receivable is one of the most crucial business functions: it affects the company’s cash flow, profitability, and ultimately its success.

• The accounts receivable department is responsible for recording, controlling, and collecting payments due from the sale of goods and/or services.

• Accounts receivable’s mission is to do everything it can to ensure the business collects its debts.

KEY CONCEPTS

Slide #1 Importance of Accounts Receivable

• Accounts receivable is vital to effective business operations.

  • If a business cannot promptly and accurately collect its debts, its days will be numbered!

  • Accounts receivable is the money a business is owed from providing products and/or services to customers on credit.

    • By offering items on credit, businesses increase both their sales and customer base.

  • Accounts receivable serves as a short-term “IOU” from its customers.

  • The success of this department directly reflects a company’s profitability—this money is the business’s income and is considered a current asset, which customers will pay within one year or less.

    • Its sales invoices are an important budgeting tool as they offer data on expected revenue, aiding in planning future business purchases or improvements.

• Businesses often calculate their accounts receivable turnover ratio to gain insight into how quickly customers pay their debts.

  • The faster you collect your money, the faster you can invest in production and other business activities, and the better your cash flow.

  • If you have a lower turnover ratio, this is indicative of an ineffective collection department, poor collection policies, and/or substandard customers.

  • Companies can increase their turnover ratio by setting automatic frequent payment reminders, offering incentives for early payments, and improving billing efficiency.

  • Money the business collects through accounts receivable fuels its economic growth.

Slide #2 Cash Flow and Accounts Receivable

• Accounts receivable directly impacts cash flow.

• The more quickly customers pay their bills, the greater the cash a business has available to pay debts, increase efficiency, and optimize operations.

• Businesses aim to increase their cash flow using a few options.

  • Companies can set strict payment time frames (e.g., 30 days or less) to increase the money coming into the business.

  • Companies can also offer cash discounts as incentives for customers to pay their bills more quickly—businesses usually offer a two percent discount for customers who pay within 10 days.

  • Likewise, businesses can apply late fees for delayed payments.

  • Finally, companies can implement a short interest-free period (e.g., 30 days interest-free grace period), then charge interest on payments after that time frame.

Slide #3 Accounts Receivable Controls

• Businesses should implement rigorous internal controls to ensure timely payment of debts and limit the potential for fraud, inaccuracy, or loss.

  • Companies often require credit approval before shipping products, either for all goods or orders over a certain amount.

  • Businesses should proofread invoices and check authorization levels, review addresses and contact details, and verify contract terms to ensure prompt payments.

  • Similar to accounts payable, companies should separate employee responsibilities and closely monitor access to billing software.

  • Businesses should also review journal entries, audit invoice files, and match all billing details with shipping logs.

• Companies can mitigate risk by employing well-documented policies and thoroughly training all accounts receivable employees, as well as fulfilling regular process spot checks.

  • Each step from preparing sales invoices, posting accounts receivable ledgers, and recording uncollectible accounts must be documented and reviewed to ensure the business’s control procedures are effective.

Slide #4 Accounts Receivable Process/Workflow

• The accounts receivable process is as follows:

  • Create credit approval process for customers:

    • Develop a credit application that follows federal credit practice laws and clearly lays out the business’s terms and conditions.

    • Credit terms generally range from 30-60 days, although days can be tightened to adjust cash flow.

  • Create invoices:

    • Immediately send the invoice (electronically or via mail) with prominent payment terms when the purchase is completed.

    • Track in your accounting system and organize by invoice number and payment date in the accounts receivable aging schedule.

  • Track balances:

    • Run a weekly accounts receivable aging report to stay on top of customers’ payments.

    • Schedule regular reminders for customers on upcoming payment due dates.

  • Process payments:

    • After receiving payments from customers, record in your accounting system and ensure payments are accurate and posted to the correct account.

    • One way to increase payments is by offering several payment options, including online bill pay.

  • Process uncollectible amounts:

    • When a customer does not, or is unable to, pay their debt, businesses must establish accounting processes for reporting the uncollectible amount (or bad debt expense).

    • Use the direct write-off method, where the amount is a direct loss that lowers net income, or the allowance method, where you estimate the amount overall.

    • Businesses estimate their bad debt expense by determining the percentage of uncollectible sales or receivables they expect to incur, which is included in budgeting efforts.

2.7 Impact of Accounts Receivable—Discussion Guide

Performance Indicator: Analyze the impact of accounts receivable collection on working capital

THINK ABOUT IT

When people purchase goods and services from a company, they often use credit, which lets them purchase now and pay later.

• To manage the money that is due to them, businesses use accounts receivable.

• Read on to learn more about the impact of accounts receivable on working capital.

KEY CONCEPTS

Slide #1 The Impact of Accounts Receivable Turnover

• Accounts receivable (AR) is all monies owed to a company by its customers.

  • For example, a water company sends a bill to its customers after they have received water with the expectation that the amount due will be paid by a deadline.

  • In the meantime, the company records the unpaid invoice using AR.

    • (Think of this invoice as an accepted “IOU.”)

• Accounts receivable turnover measures how efficiently a company extends credit and collects payment.

  • This ratio also measures how many times the company converts its receivables to cash in an accounting period.

• Typically, a high AR turnover ratio is preferred, as this indicates that a business has a large number of customers who pay back their debts to the company quickly.

• It’s also possible that the ratio indicates the company implements a relatively conservative credit policy.

  • The advantage of a conservative credit policy is that it helps companies avoid extending credit to customers unable to pay; the disadvantage is that customers may flock to a competitor with a more relaxed credit policy.

• A low AR turnover ratio indicates that a company must reassess its credit and collection procedures.

• AR turnover can have a great deal of impact on the cash flow of a business—after all, if customers aren’t paying their debts on time (or at all), the company is missing out on the possession of that money, which affects its ability to reinvest in the business and other growth opportunities.

• Efficient collection of monies owed is crucial to maintaining a healthy and profitable business.

Slide #2 The Impact of Days Sales Outstanding

• Days sales outstanding (DSO) measures the average time (in days) it takes a company to collect payment after making a sale.

• Evaluating a company’s DSO over time can provide insight into its cash flow, because the sooner a company collects due payments, the sooner it has capital (cash) in hand.

  • It is preferable to have a low DSO, because this means it takes the company fewer days to collect its payments.

  • A high DSO means a company might take too long to collect payments from customers, meaning the business goes without owed money for extended periods of time.

Slide #3 The Impact of Bad Debts Percentage

• In a perfect world, everyone would repay their debts in full and on time.

• Unfortunately, that’s not the case—and businesses must be prepared to accept the potential consequences of bad debts.

• Bad debt is money owed to a company that is unlikely to be paid.

• When companies extend credit to customers, there is always a risk that the company will not be paid as expected (or at all).

  • Think of the water company example from earlier: The company allowed its customers to receive its product (water) before it received payment.

  • If a portion of those customers do not pay their bills, the company records this as bad debt.

• The percentage of bad debts, then, represents the amount of uncollectible debt a business incurs when extending credit to customers.

  • Typically, the longer a debt remains unpaid, the more likely it is that that debt will remain unpaid.

• While businesses (and individuals) can write off bad debts on tax returns to decrease the amount of tax they need to pay, bad debts are still an expense that businesses must absorb as a cost of conducting business using credit.

• Obviously, bad debt is not good for a company, as it represents goods given and/or services rendered without payment.

• This decreases the amount of capital that a company has on hand and affects its investment and growth opportunities.

  • If a company experiences an increased amount of bad debts, its working capital is decreased, because the company has not been (and will not be) paid.

  • If a company experiences a decreased amount of bad debts, then the company will have more working capital on hand to contribute toward company operations.

Slide #4 The Impact of Adjusting Reception Terms

• Terms are specific points that reveal each party’s expectations and responsibilities in a negotiation agreement.

• More specifically, accounts receivable terms lay out the rules for how and when a payment must be made.

• When customers purchase items on credit, they agree to payment terms set by the business when extending the credit.

• Any adjustment of AR terms impacts a business’s working capital.

  • For example, if terms are shortened, then the customers must pay back debts sooner, which gets capital back into the hands of the company at a faster rate.

  • Alternatively, if terms are lengthened, the customers have more time to pay back their debts, which means companies must wait longer to receive the cash they are due.

  • In turn, this means companies must wait to use any available capital for their own endeavors.