What are Accounts Receivable?

An IOU is cash in your pocket tomorrow...

And that’s how companies consider accounts receivable (A/R) – It's like a collection of IOUs from customers. Companies list them as assets in their financial statements because they’re expecting the cash soon. But cash is king – Companies would rather have the cash in their pockets now than cash that comes later from accounts receivable. A/R may not be as desirable as cash because of the order of liquidity, aka the amount of time it takes to turn an asset or security into cash.

Investors study accounts receivable in a company’s financial statement to find out more about a company’s total assets.

Companies that offer credit to their customers can reach a wider customer base, which could help them be more competitive in their marketplace. Accounts receivable is the way that a company tracks the amount of money its customers owe them for products and services it sold on credit.

A company keeps track of unpaid invoices on an “Accounts Receivable Aging Report,” or schedule of accounts receivable. It shows how many customers have paid for the product or service, and how many customers’ outstanding invoices are late by periods of 30 days, 60 days, or 90 plus days.

Investors can check accounts receivable aging reports to get a feel for a company’s financial strength and liquidity. For example, a company may appear to have plenty of current assets (aka items that it can turn into cash in less than a year). But if its aging report shows that a lot of those assets are old unpaid accounts receivable, that is a sign that a company may be struggling in some areas:

• It may be taking on too much credit risk
• It may not be screening its credit customers enough
• It may not have strong credit and collection policies
• Its industry may be declining
• There could be issues with its products or services

Accounts receivable play a key role in the accounting department of a company. Companies calculate accounts receivable as an increase in a company’s revenue. A company’s revenue is what it earns by selling products and services even if cash isn’t received at the time of the sale or service. A company lists a credit transaction as an account receivable instead of a cash asset on its balance sheet.

Companies list accounts receivable as a current asset because they think they can collect it over the short-term. When customers pay their bill, the company subtracts it from accounts receivable, and then adds it to cash. The amount of revenue stays the same.

Of course, not all debts are good debts. Companies have two ways of accounting for customers who don’t pay. If a company is certain that a customer won’t pay, they can write-off the amount owed as a bad debt (direct write-off). But it must do this within the accounting period that the sale happened, according to the rules of accrual accounting.

If a company isn’t sure whether customers who owe money will pay in the future, it has to account for this somehow on its financial statements. So, it creates a negative account called a bad debt allowance that estimates what might not be collectible in its accounts receivable. The company also creates a bad expense account of the same amount to offset its revenues. This helps it stay honest about its true profitability.

If a customer doesn’t pay, a company has to either perform a direct write-off or create a bad debt allowance. It can’t carry an unpaid account receivable over to the next accounting period and continue to record the revenue in the previous accounting period.

Why? In an accrual accounting system, a company has to match the bad debt expense with the revenue it helped generate in the same accounting period. If a company doesn’t do this, it risks lying to its investors about its equity in three ways:

• Overstating assets for the previous year
• Understating expenses for the previous year
• Overstating expenses for the current year

If a company is certain that it won’t collect on a debt, it can write the debt off. To do this, it subtracts a customer’s account from accounts receivable and adjusts the revenue by including the bad debt as an expense. Companies have different criteria for deciding when they should write-off bad debt.

But what if a company thinks some customers might pay later, though it’s not sure which ones? It wants to try and be as honest as possible about the profitability of sales on its balance sheets and income statements.

First, the company has to estimate the percentage of its accounts receivable that it believes customers won’t pay in the future.

Then it creates a negative account that sort of acts like a deduction from the accounts receivable assets. This is a type of “contra asset account” (against asset). Accounting calls this an Allowance for Doubtful Accounts (ADFA) or “allowance account.”

Finally, the company has to create a bad debt expense account in the amount of its estimate of the unpaid debt to show a potential change in its total revenue.

For a visual of what this looks like in action, let’s check out an imaginary company, Bodacious Robots.

Bodacious Robotics has an accounts receivable balance of $100K and thinks that about 2% of its customers won’t pay for their bots. It creates an allowance for doubtful accounts of $2K (2% of $100K) and a bad debt expense of $2K.

The Bodacious Robotics’ income statement for the end of that accounting period will show a net accounts receivable balance of $98K ($100K - $2K). It will also show a bad debt expense of -$2K, which reflects the potential change in its revenue.

Investors can study the change in a company’s bad debt allowance account over time. If a company’s bad debt allowance has increased a lot over time, it may mean that a company doesn’t have strong credit and collection policies. But if a company’s bad debt allowance has decreased a lot, it may mean that it has had to write off a large part of its debt. This could show a problem with its financial condition.

People can owe companies money, but businesses can owe debts to others, too.

Companies can extend credit to both customers and businesses for the sale of products and services. When Company A sells something to Company B on credit, Company A records its sale as an account receivable asset. But Company B records the amount it owes to Company A as an account payable liability. Current liabilities are a company’s short-term credit obligations. They are usually amounts owed by a company that has an ongoing relationship with its suppliers.

Let’s imagine that Tom’s Pizza Temple orders its pizza dough from Bill’s Dough & Mo’ (both made up companies). It’s much easier for Tom to be able to pay for the dough a few times a year than to have to pay up every time he needs to make a bunch of pizzas. Bill records the sale of the pizza dough in his accounts receivable, and Tom records what he owes for the pizza dough in his accounts payable. Bill sends an invoice to Tom, and Tom pays it so people can keep eating pizza, and his business can keep running.

The Accounts Receivable Turnover Ratio (ART) measures how fast and how often a company collects cash owed by its customers. You can calculate the accounts receivable turnover ratio in three steps.

1. Add the accounts receivable amount at the beginning of the year to the amount of the accounts receivable at the end of the year.
2. Divide the total by two to get the average accounts receivable.
3. Divide the total net credit sales (total credit sales minus any returns or refunds) by the average accounts receivable.

Let’s figure out the accounts receivable turnover ratio of the imaginary company Tiger Lilly Tea for 2018:

1. January 1st accounts receivable $90K + December 31st accounts receivable $100K = $190K.
2. $190K/2 = $95K average accounts receivable.
3. Total net credit sales $700K/$95K = 7.4.

Tiger Lilly Tea collected its accounts receivable average 7.4 times in 2018, or approximately every 49 days (365 * $95K/$700K). When shown in days, it’s called Days of Sales Outstanding (DSO), or the “average collection period.”

Investors can track a company’s accounts receivable turnover ratios to look for trends.

• If there is a high turnover ratio, a company may be good at turning its outstanding accounts into cash.
• If there is a low turnover ratio, a company may need better credit policies or debt collection processes.
• If the turnover ratio is too high, a company might not offer customers enough credit options.

An accounts receivable-to-sales ratio (A/R to sales ratio) is the percentage of a company’s sales that are credit transactions. To figure the A/R to sales ratio:

• Yearly total accounts receivable/total sales (cash and credit) = A/R to sales ratio

For example, suppose Parcelplow Farms — an imaginary company — had total accounts receivable of $5K in 2018 and total sales of $25K for the same year. You can figure its A/R to sales ratio by dividing $5K by $25K, which would give you 20%. So, Parcelplow has 20% credit sales to 80% cash sales in 2018.

Accounts receivable-to-sales ratios can give investors insight into a company's cash flow. For example, a company with an A/R to sales ratio that is too high may run out of the cash it needs for day-to-day operations during slow sales periods.