Accounts Receivable: What it is and How it Works

A comprehensive guide to understanding accounts receivable: definition, explanation, and how it works

What is Accounts Receivable?

Accounts receivable is a term used in finance and accounting to refer to the money that a company is owed by its customers. It is essentially a legally enforceable claim for payment held by a business for goods supplied or services rendered that customers have ordered but not paid for. These are generally in the form of invoices raised by a business and delivered to the customer for payment within an agreed time frame.

Understanding the Role of Accounts Receivable

Accounts receivable is an important aspect of a businesses’ fundamental analysis. It is considered an asset on a company’s balance sheet. When a company sells a product or service but has not yet collected payment, it creates an account receivable. This is recorded as a current asset on the balance sheet, as it is expected that the customer will pay within a short period.

The Importance of Accounts Receivable

Accounts receivable is important because it represents revenue that is owed to the company. It is revenue that is yet to be realized. It is an indication of the company’s health and performance. A company with a high amount of accounts receivable indicates that the company has a good number of customers who are willing to purchase its goods or services on credit. This is a positive sign for investors and creditors.

How Accounts Receivable Works

When a company sells goods or services to a customer on credit, it creates an account receivable. The company records the amount of the sale as an account receivable on its balance sheet and records the revenue on its income statement. The customer is then obligated to pay the company within the agreed credit period.

Accounts Receivable Collection

Once the credit period is over, the company will attempt to collect the payment from the customer. This is typically done by sending a reminder or a collection letter to the customer. If the customer fails to pay, the company may take further action, such as hiring a collection agency or taking legal action.

Managing Accounts Receivable

Managing accounts receivable effectively is crucial for maintaining the cash flow of a business. This involves monitoring the amounts and due dates of outstanding invoices, following up on late payments, and taking action when necessary. Companies often use accounts receivable software to automate these tasks and improve efficiency.

Accounts Receivable Turnover Ratio

The accounts receivable turnover ratio is a key financial metric used to evaluate a company’s effectiveness in managing its accounts receivable. It is calculated by dividing total net credit sales by the average accounts receivable during a certain period. A high ratio indicates that the company is successful in collecting its receivables.


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