Written by Team 365 finance
Accounts receivable, or AR, is the money that’s owed to a business but hasn’t yet been paid by its customers.
Businesses that provide goods or services on credit have accounts receivable. The customers or clients of the business might pay off their line of credit every week, every month or, in some industries, every quarter.
When a business sells a product or service on credit, it’s recorded in the general ledger account called accounts receivable. Accounts receivable are viewed as part of a business’s assets, even though they haven’t yet been collected.
Below, we’ve explained what accounts receivable are, why they’re important for a business and how they’re typically managed. We’ve also explained some of the risks of providing trade credit to customers and how these can affect a business’s accounts receivable.
What is Accounts Receivable (AR)?
Accounts receivable is the money that’s owed to a business by its customers or clients. In the world of business-to-business (B2B) trading, businesses regularly extend trade credit to their customers, allowing their customers to buy things on account rather than up front.
For a business that supplies other businesses, trade credit can be an important part of finding and attracting new customers. Many businesses prefer to pay for goods and services at a later date, making it important for suppliers to offer this to their customers and clients.
When a business supplies goods and services to another business or entity, it issues them with an invoice. This invoice specifies a date at which the payment is due, as well as the amount of money that’s owed by the customer.
The amount listed on the invoice becomes part of a business’s accounts receivable. Businesses have a legally enforceable claim to this amount of money, as it’s part of the contracts they make with their customers and clients.
Examples of Accounts Receivable
Accounts receivable can range from payments for physical goods to money owed to a business for services it’s provided. Most money owed as accounts receivable fits into one of the following categories:
- Payments for physical products. Physical products, such as equipment, inventory or custom made items can be sold on trade credit, with the total amount owed added to a business’s accounts receivable.
- Payments for services. Businesses that provide services, such as a design agency or lawyer’s office, commonly provide these services on credit, allowing their clients to pay for them at a later date.
- Payments for assets. Some businesses may allow their customers to pay for assets, such as real estate or other property, as part of a trade credit agreement. This amount owed is added to a business’s accounts receivable and collected at a later date.
Why Accounts Receivable are Important
Accounts receivable are important for both suppliers and the customers they work with. For a business that supplies other businesses, offering trade credit can make them more appealing than their competitors.
In order to offer trade credit to a customer, a business needs to know that the customer is able to pay them in full and on time. Trade credit is typically a form of unsecured credit, meaning the business offering it doesn’t hold any type of asset as collateral.
Most businesses will look at a customer’s credit history, assets and other factors before offering trade credit. This helps a business minimize its total amount of bad debt — debts that are owed but aren’t likely to be paid in full or on time.
For customers, trade credit allows a business to buy inventory, services and other items without dealing with an immediate hit to cash flow. For example, a retail electronics business can use its trade credit with a supplier to buy TVs and other items, then pay for them at a later date.
This allows a business to receive important supplies and generate revenue in the short term, all without having to take out a line or credit or loan.
The Risks of Accounts Receivable
While a business’s accounts receivable is considered a current asset, it’s not viewed as a cash equivalent asset. A business can’t use its accounts receivable to pay its own bills, for example, or to purchase new goods or services of its own.
Over time, accounts receivable can make up a significant percentage of a company’s balance sheet. This makes it important for businesses to actively follow up on and collect debts they’re owed by customers.
The biggest risk of accounts receivable is that a customer might not pay. If a customer goes out of business, this can affect the ability of the business that extended credit to collect the money that it’s owed.
To limit this risk, businesses that offer trade credit are careful not to extend credit to businesses with cash flow issues or limited assets. Many businesses that offer trade credit limit the amount that high-risk customers can borrow, or request that they pay upon delivery.
Sometimes, a business will use practices such as factoring to receive immediate cash using the value of its accounts receivable. This is typically used when a business needs to generate cash flow in the short term, before its customers are required to pay their debts.
Accounts receivable is an essential part of almost every B2B business. By extended trade credit to its customers, a business that supplies other businesses can build closer relationships with its customers and generate more revenue over the long term.
Like other forms of credit, a business needs to carefully monitor its accounts receivable to make sure it’s paid in full and on time. Companies that are smart about extending trade credit tend to have fewer bad debts and more reliable, consistent cash flow.