The world of accounting for small business can be a confusing one.
There are so many dizzying terms that swirl around — income statements, working capital, revenue, liabilities, assets — the list goes on.
If you’re just starting your own small business, you’ll need to be able to manage — or at least be a little familiar with — many of these terms.
One of these, which you’ll encounter on your company’s balance sheet, is accounts receivable.
You might be thinking “What is accounts receivable?”
Don’t worry, you’re not alone.
In this article, we’ll go over what the accounts receivable section is on your company’s balance sheet.
Plus, we’ll cover what constitutes a healthy accounts receivable balance, and go over other balance sheet terms you should know.
- What Is Accounts Receivable?
- Example of Accounts Receivable
- Accounts Receivable vs. Accounts Payable
- Measuring the Health of Accounts Receivable
- Additional Balance Sheet Terms
- Keep Track of Your Accounts Receivable
What Is Accounts Receivable?
Accounts receivable is the amount a company is owed by customers for providing goods or services on credit rather than being paid upfront with cash.
In accounting terms, accounts receivable are considered a current asset on a company’s balance sheet.
In many instances, companies will give goods or services to customers and have them pay afterward.
The money that’s owed for these transactions is recorded within the accounts receivable ledger.
With certain clients and customers, a company may allow them to purchase goods and services on credit.
Most companies — whether it be a service-based graphic design company or an online eCommerce store — will buy or sell goods and services on credit.
This makes it easier to make exchanges without having to pay upfront every time.
And instead of giving 20 invoices to a client throughout the month, companies will give one bill at the end of the month that includes the entire month’s balance owed.
However, companies should be wary about overextending themselves and letting customers purchase a great deal on credit.
There will always be a handful of customers who won’t follow through with their obligations and pay off what they purchased on credit.
Proper accounting practices require companies to come up with an estimate of unpaid invoices and loans.
On a company’s balance sheet — or the official financial statement that keeps track of a company’s financials — this estimate of unpaid loans will be tracked under the allowance for doubtful accounts section.
This section safeguards your company from unpaid debts so they don’t sneak up and surprise you when it’s time to balance your books.
Example of Accounts Receivable
Essentially, an account receivable is like an IOU from a seller to its client.
Until the client pays the debt, the company will have an accounts receivable balance.
To give you a real-world example, let’s think about a graphic design company.
A graphic design company can sell and complete $1,000 worth of design services for one of their clients and give them payment terms of 30-days to pay back the balance.
This means that the company extends a $1,000 line of credit to their client.
The company will then add $1,000 to their balance sheet in the accounts receivable section.
When the customer pays off the balance for the completed services, the amount will be subtracted and transferred into the company’s cash balance.
Accounts Receivable vs. Accounts Payable
Accounts receivable and accounts payable are the opposite of one another.
If accounts receivable is the money a company is owed, then accounts payable is the money a company owes to other companies.
Accounts receivable fall under a company’s assets section on the balance sheet.
On the other hand, accounts payable are considered current liabilities.
Like accounts receivable, a company doesn’t want a large amount of money on its accounts payable balance.
It’s best to pay off these short-term debts as soon as possible.
Going with the same example we used above, a graphic design company could have a balance in their accounts payable section for a few different reasons.
Some examples could be owing money to their internet service provider or owing an electronics store for purchasing a laptop on credit.
Measuring the Health of Accounts Receivable
The faster a company can collect on their accounts receivable, the better the overall health of their business will be.
This can be measured through an accounts receivable turnover ratio or a days sales outstanding analysis.
Accounts Receivable Turnover Ratio
The accounts receivable turnover ratio measures how fast a company collects debts from its clients.
This ratio shows how a company manages its credit lines and how effective it is at receiving payments from clients.
To calculate the accounts receivable turnover ratio, you need to take an average of the balance of your accounts receivable at the beginning and end of a selected time period.
This will be the “Net Credit Sales” in the equation below.
You’ll then add up the total net credit sales for the same time period.
After that, complete the following equation and you’ll come up with your accounts receivable turnover ratio.
Accounts Receivable Turnover = Net Credit Sales ÷ Average Accounts Receivable
If a company has a high turnover ratio, this means they’re able to successfully collect debts on a regular basis.
This implies that their customers are trustworthy, reliable, and capable of paying their debts.
If the ratio is lower, companies struggle with collecting their debts.
This means that a company doesn’t have the proper credit procedures in place to adequately collect debts or that their customers are unreliable and incapable of paying back what they borrowed.
Days Sales Outstanding Analysis
The days sales outstanding ratio measures how many days on average it takes a company to collect its debt after a sale has been made.
It can also be referred to as the average collection period.
Since cash is the lifeline of any business, it’s imperative that companies collect their debts as soon as possible.
The more cash on hand and the lower the credit amount extended to clients, the better off a company will be.
The days sales outstanding ratio can be calculated using the equation below.
Days Sales Outstanding = (Accounts Receivable ÷ Total Credit Sales) x Number of Days
A higher days sales outstanding ratio means that a company is taking too long to collect payment from its customers.
This can cause cash flow problems since companies are unable to inject this cash back into the business.
A lower days sales outstanding ratio means that a company is receiving payment in fewer days and that the company has a healthy cash flow.
They can then take this money and use it for business initiatives that will help the company grow.
Both of these ratios are important to track a company’s effectiveness at collecting debts and should be tracked in tandem with one another.
The accounts receivable turnover ratio can be looked at on an annual basis while the days sales outstanding ratio gives you a more granular view of your debt collection throughout the fiscal year.
Additional Balance Sheet Terms
The balance sheet is made up of three sections — assets, liabilities, and shareholder’s equity.
The balance sheet details everything a company owns, what it owes others, and how much equity shareholders own.
Current assets can be converted into cash quickly in one calendar year or less.
On the balance sheet, they’re ordered from the assets with the highest liquidity to the lowest liquidity.
Here are a few examples of what might show up on the current assets section of the balance sheet.
- Cash and cash equivalents: This is the most liquid asset, and includes hard cash, Treasury bills, and short-term certificates of deposit.
- Marketable securities: These include any securities, like a Treasury bill or short-term CD, that can be easily converted to cash and typically mature within one year.
- Inventory: These are goods available for sale that a company has on hand.
- Prepaid expenses: This includes any expenses that a company has paid for in advance.
Long-term assets take longer than one year to convert into cash.
Here are some examples of long-term assets a company may have.
- Long-term investments: These are any investments, like long-term bonds or real estate, that cannot be liquidated within one year.
- Fixed assets: These include equipment, land, machinery, and other expensive assets a company has invested in.
- Intangible assets: These include non-physical assets like intellectual property or goodwill.
Current liabilities are the line items a company must pay within one year.
There can be many different types of current liabilities, with a few examples explained below.
- Interest payable: This is any interest a company still owes on a loan or credit-based purchase.
- Wages payable: This is the money that a company owes to its employees.
- Rent, taxes, and utilities: These are basic expenditures a company owes for operating its business.
Long-term liabilities are the expenditures a company can pay off after one year.
- Long-term debt: This includes the interest and the principal of debt that matures in more than a year, like with Treasury securities, municipal bonds, and corporate bonds.
- Deferred tax liability: This is any tax debt that has accumulated but will be paid in more than one year.
Shareholder’s equity is the money that goes towards the company’s owners.
This is the portion of the company that the shareholders own.
- Retained earnings: These are net earnings — or the profits left over after a company pays out dividends to stockholders — can be used to reinvest into the company to help it grow.
- Common stock: This is a stake of ownership in a company.
- Preferred stock: This is also a stake of ownership in a company except with higher dividend payments.
Keep Track of Your Accounts Receivable
It’s important that you stay on top of your company’s accounts receivable balance.
While it’s alright to extend a line of credit to reliable customers, you don’t want to make it a habit to do business with customers who are slow to pay back their debts or do not pay at all.
The faster you can get these debts off your books, the healthier your company will be.
If you already have an established business, you can check out Wave accounting software for small businesses to help you manage your balance sheets.
If you’re interested in becoming an entrepreneur, check out our 10 step guide to starting your own business.