What is accounts receivable (AR)?
– Accounts receivable are amounts a business expects to collect from customers for goods or services already delivered but not yet paid for. Under accrual accounting, revenue is recognized when earned, so the customer’s unpaid invoice becomes an asset on the seller’s balance sheet until cash is received.
Key definitions
– Accounts receivable (AR): Customer balances for billed—or billable—sales that remain unpaid.
– Current asset: An asset expected to be converted into cash within 12 months; AR is usually classified here.
– Allowance for doubtful accounts: A contra‑asset that estimates receivables unlikely to be collected.
– Net receivables: Gross AR minus the allowance for doubtful accounts.
– Accounts payable (AP): Money the company owes others (the opposite of AR).
– Factoring / discounted receivables: Selling receivables to a third party for immediate cash, typically at a discount.
– Bad debt write‑off: Removing an uncollectible receivable from the books and recognizing an expense.
Why AR matters
– Liquidity: AR contributes to working capital and short‑term liquidity because those amounts are expected to become cash.
– Credit risk: Large or growing AR relative to sales can signal collection problems or loose credit terms.
– Cash flow: Even profitable companies can struggle if receivables pile up and cash isn’t collected on time.
Where to find AR on the financial statements
– Balance sheet: Listed under current assets as “Accounts Receivable,” often shown as gross receivables with a separate line for the allowance for doubtful accounts. Notes/footnotes often include aging schedules, concentration of credit risk, and allowance methodology.
When is a receivable created?
– A receivable arises when the company has satisfied its performance obligation (delivered goods or rendered services) and billing terms allow payment later. In practice this often occurs at invoicing or when title/ownership transfers.
What happens if customers don’t pay?
– Estimate and record an allowance for doubtful accounts to anticipate losses.
– If collection fails, record a write‑off that reduces gross AR and the allowance.
– Companies may pursue collection efforts, sell the receivable to a factor, or turn it over to a collection agency. Each action affects cash, expenses, and possibly financing costs.
Key ratios and how to compute them
– Accounts receivable turnover ratio = Net credit sales / Average accounts receivable
– Measures how many times AR is collected during a period.
– Days sales outstanding (DSO) = (Average accounts receivable / Net credit sales) × Days in period
– Shows the average number of days it takes to collect a receivable. Alternatively DSO = Days in period / Receivables turnover.
Assumptions to note
– Use net credit sales (sales made on credit) rather than total sales if cash sales are material.
– Average accounts receivable = (Beginning AR + Ending AR) / 2, unless more granular averaging is available.
Worked numeric example
Assume:
– Net credit sales for the year = $1,200,000
– Beginning accounts receivable = $100,000
– Ending accounts receivable = $140,000
– Allowance for doubtful accounts (end of year) = $6,000
Calculations:
1) Average AR = (100,000 + 140,000) / 2 = 120,000
2) AR turnover = 1,200,000 / 120,000 = 10.0
– Interpretation: AR was collected 10 times during the year.
3) DSO = 365 / 10 = 36.5 days
– Interpretation: On average it takes about 36.5 days to collect a credit sale.
4) Net receivables = Gross AR (use ending AR 140,000) − Allowance 6,000 = 134,000
5) Allowance as % of gross AR = 6,000 / 140,000 = 4.29%
– Interpretation: Management expects roughly 4.29% of receivables may be uncollectible.
Checklist for assessing accounts receivable (for analysts and managers)
– Confirm AR is recorded as a current asset on the balance sheet.
– Calculate AR turnover and DSO and compare to prior periods and industry peers.
– Examine the allowance for doubtful accounts: trend, methodology, and percent of gross AR.
– Review aging schedule: distribution across 0–30, 31–60, 61–90, 90+ day buckets.
– Check receivables concentration: percentage owed by top customers.
– Watch AR growth relative to sales growth (fast AR growth with slower sales growth can be a red flag).
– Note any factoring, securitization, or significant sales of receivables in the notes.
– Evaluate credit terms and any recent changes (e.g., extended terms or promotional financing).
Practical steps to manage receivables (operations)
1) Define clear credit policies and approval limits.
2) Invoice promptly and accurately; automate where possible.
3) Monitor aging daily/weekly and prioritize collection on overdue high‑balance accounts.
4) Offer incentives for early payment and enforce penalties for late payment if appropriate.
5) Use credit insurance or factoring if cash flow needs require it.
Summary
Accounts receivable reflect amounts owed to a firm for products or services delivered but not yet paid for. They are a current asset and a core component of working capital. Key metrics—AR turnover and DSO—help evaluate collection efficiency and credit quality. Allowances and write‑offs address expected losses; factoring transfers collection risk but at a cost.
Sources
– Investopedia — Accounts Receivable (AR): https://www.investopedia.com/terms/a/accountsreceivable.asp
– U.S. Securities and Exchange Commission (Investor.gov) — How to Read Financial Statements: https://www.investor.gov/introduction-investing/investing-basics/how-read-financials
– Corporate Finance Institute — Accounts Receivable: https://corporatefinanceinstitute.com/resources/accounting/accounts-receivable/
Educational disclaimer
This explainer is for educational purposes only and does not constitute personalized investment, accounting, or legal advice. For decisions that affect your business or investments, consult a qualified professional.