Accounts receivable revenue can be confusing for small businesses because it’s money that’s owed but hasn’t yet been paid.
When you offer customers or clients goods and services on credit, your accounts receivable keeps track of what’s owed to you and when. A solid accounts receivable process can improve cash flow by making sure you get paid on time according to the payment terms of your contracts with customers.
But how is accounts receivable recorded on your balance sheet? Keep reading to find out more about the definition of accounts receivable as it relates to assets, revenue, liabilities, and equity.
Table of Contents
- Is accounts receivable an asset?
- Is accounts receivable considered revenue?
- What are other assets for small businesses?
- What else is considered revenue for small businesses?
- What is considered a liability for a small business?
- What is considered equity for a small business?
- What do assets, liabilities, and equity look like on a balance sheet?
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5 tips to improve your accounts receivable (AR) turnover ratio
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Track and improve accounts receivable turnover ratio with accounting software
Accounting Definitions Cheat Sheet
|
Asset |
Something your company owns |
|
Revenue |
Your company’s income |
|
Liability |
Debt your company owes |
|
Equity |
Leftover assets after liabilities |
Is accounts receivable an asset?
Yes, accounts receivable is an asset on your balance sheet. For businesses that use accrual accounting (as opposed to cash basis accounting), accounts receivable is an asset that will soon be converted to cash, usually within 30, 60, or 90 days.
If your accounts receivable takes longer than one fiscal year to convert to cash, it’s considered a long-term asset that may be offset by what’s called “allowance for uncollectible accounts.”
Allowance for uncollectible accounts estimates the amount of bad debt your business will see in any given time period. Bad debt is accounts receivables your business can’t collect from customers, either because they won’t pay you or they’ve gone bankrupt.
The difference between your gross accounts receivable and your anticipated allowance for uncollectible accounts is the accounts receivable asset your business can expect to convert to cash.
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Is accounts receivable considered revenue?
Yes, businesses that use accrual accounting record accounts receivable as revenue on their income statement. That’s because accounts receivable is considered revenue as soon as your business has delivered products or services to customers and sent out the invoice.
Businesses need to be diligent about tracking their accounts receivable because it’s considered revenue. If you’re not tracking your accounts receivable with automation, you’re also not tracking cash flow — and that’s where your business can get into trouble.
When you offer customers goods and services on credit, you’re trusting that they’ll deliver on your payment terms — but that’s not always the case. Keep a close eye on your ratio between your accounts receivable and cash on hand, as that will tell you whether or not you can anticipate any cash flow issues.
Get in-depth knowledge of the ideal accounts receivable process here.
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What are other assets for small businesses?
Business assets are anything your business owns, but that can come in many forms. You’ll want to categorize your assets as “current assets”, “fixed assets”, and “other assets.
Current assets are short-term. They’re the assets you spend on running your business day-to-day, and they’re usually spent within a year.
Fixed assets are long-term. Physical assets like property and equipment are “fixed” because they last a lot longer than one fiscal year; in fact, you probably really depend on them to run your business for the long haul.
Examples of Current Assets
Examples of current assets include:
- Cash on hand
- Accounts receivable
- Equity or debt securities
- Inventory
- Prepaid expenses — goods or services you’ve paid for but have yet to receive in full
Examples of Fixed Assets
Examples of fixed assets include:
- Real estate and land
- Vehicles
- Office furniture
- Equipment
Keep in mind there are also intangible assets, which are things like patents, brands, trademarks, or copyrights. Your intangible assets don’t appear on your balance sheet.
See a complete list of asset classifications here.
What else is considered revenue for a small business?
When you’re using accrual accounting for your small business, you’re tracking revenue with an accounts receivable process. This means you may be tracking multiple revenue streams, for goods or services or both.
Accounts receivable can help you track the following:
Transaction revenue: One-time payments from the sale of goods
Service revenue: One-time payment from the sale of services, such as consulting, writing, design, etc.
Recurring revenue: Ongoing payments from customers from the sale of goods or services. Retainers, subscriptions, and licensing all fall under recurring revenue.
Keeping track of your accounts receivable becomes even more important when you’re dealing with multiple revenue streams. Use accounting software like Quickbooks or Xero with a payments integration like Plooto to automate the process and make sure your cash flow is flowing.
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What is considered a liability for a small business?
Your liabilities are your debts. Debts may include accounts payable, mortgages, bank loans, etc. Accounts payable is the amount of money your company owes to suppliers or creditors.
On your balance sheet, accounts payable is listed as a liability because it’s money that will flow out of your business within a certain period of time, depending on your payment terms with creditors and vendors.
Quick tip: Make payments on your accounts payables as close to their due date as possible to better manage cash flow.
Examples of a liability
Here are some examples of what’s considered a liability:
- Accounts payable
- Interest on debt
- Salaries, wages, and benefits you owe to staff
- Debts you owe
- Utility contracts
- Leases
- Insurance
- Income tax and sales tax
- Legal costs
- Pre-payments for goods and services you haven’t yet provided
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What is considered equity for a small- to mid-sized business?
Equity is what’s left over after you’ve subtracted your liabilities from your assets. It’s the net worth of your business.
If you’re a sole proprietor, you’ll list your “owner’s equity” on your balance sheet. If you’re a corporation, a variety of shareholders own your business equity.
Equity is mostly known as stock, but that’s a simplification. There are a few types of stocks:
Preferred stock
People who own preferred stock get paid out before common stock is paid out to common shareholders
Capital
Leftover cash after a founder’s initial investment in the company
Retained earnings
Whatever the owner(s) reinvests in the company’s operations rather than paying out to themselves or shareholders
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What do assets, liabilities, and equity Look Like on a Balance Sheet?
So what does all this look like on a balance sheet?
A balance sheet is made up of the following sections:
Assets
Cash and cash equivalents: Cash on hand and investments
Current assets: Your accounts receivable
Property, plant and equipment: Equipment and tangible assets
Intangible assets: Intellectual property, copyrights, etc.
Other assets: Other long-term assets
Liabilities
Current liabilities: Accounts payable and sales tax
Long-term liabilities: Debts beyond one year
Equity
The difference between your assets and liabilities
Retained earnings: Your net income, minus any payments to shareholders
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How to analyze accounts receivable
Accounts receivable are one of the most important metrics for businesses. They show how much cash a business generates and how profitable it is. But there are many different ways to analyze accounts receivable, and some methods work better than others. Here are three common accounting techniques used to evaluate accounts receivable:
- Balance Sheet Analysis
- Income Statement Analysis
- Cash Flow Analysis
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Importance of accounts receivable turnover ratio
Accounts receivable turnover ratio (AR/TVR) is one of the most important metrics used in managing a company’s finances. This metric helps companies determine whether they are making progress toward achieving their financial goals. In fact, many accounting software packages offer AR/TVR reports. However, calculating AR/TVR correctly requires careful attention to detail, especially since there are several different ways to calculate this number.
The key to an effective AR/TVR calculation is identifying accurate data. For example, some companies use gross sales as the numerator while others use net sales. Some companies include both current and previous month numbers; others do not. There are even variations within each method. When calculating AR/TVR, companies must identify the correct denominators, such as total inventory, total accounts payable, and total accounts receivable. They also need to know how much money is being collected from customers versus what amount is owed to vendors.
Once companies have identified the appropriate data points, they need to make sure that the numbers are accurate. For example, a company could report that it had $1 million in accounts receivable, but actually owe $2 million to vendors. If this happens, the actual AR/TVR percentage is negative. To avoid this problem, companies should review their AR/TVR calculations periodically to ensure that they are accurate.
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What can accounts receivable ratio tell you?
Accounts receivable ratio can help determine whether or not your customer base will pay back money owed. If you find yourself in the situation where you don't know how much money you're going to collect from a particular client, it might be helpful to look at accounts receivable ratio. This metric helps you understand what percentage of invoices have been paid off.
A low ratio indicates that your customers tend to pay back late. Your best bet is to avoid clients with high ratios because you'll likely end up having to chase payments down. On the flip side, a high ratio suggests that your customers are paying out earlier than expected. In this case, you might want to consider offering discounts to encourage payment sooner rather than later.
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How to calculate accounts receivable (AR) turnover ratio
The Accounts Receivable (AR)/Accounts Payable (AP) turnover ratio is used to evaluate how efficiently a company converts its accounts payable into cash. To calculate this ratio, you must divide the amount of accounts receivable outstanding by the amount of accounts payable outstanding. You can use the following formula to calculate the AR/AP turnover ratio:
Turnover Ratio Accounts Receivable / Accounts Payable
For example, assume that Company X had $1 million in accounts receivable and $500,000 in accounts payable outstanding at the end of the month. If Company X paid off its accounts payable within 30 days, it would have an AR turnover ratio of 0.5. However, if it took 60 days to pay down its accounts payable, the AR turnover ratio would be 0.6.
A high AR turnover ratio indicates that a company pays its bills quickly and effectively. Conversely, a low AR turnover ratio suggests that a company takes longer to convert its accounts payable into cash than it does to collect money owed to it. Companies with lower ratios are usually less efficient in paying their bills.
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What Is a good accounts receivable turnover ratio?
Accounts receivables turnover ratios measure how often customers pay bills on time. If you have high accounts receivables turnover rates, it could indicate that there is something wrong with your customer service or collections processes. You might find yourself paying too much money to vendors or having trouble collecting payments from clients. On the flip side, an accounts receivables turnover rate under 30% could indicate that you are overpaying your vendors or that your customers aren't paying their invoices on time.
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Tracking accounts receivable ratios
Accounts receivable ratios are one way to track how well your company is managing cash flow. They provide insight into whether your company is generating enough revenue to cover operating expenses and paying off debt obligations.
An accounts receivable ratio is calculated by dividing total accounts receivable by total sales, according to the Federal Reserve Bank of New York. Companies usually look at the ratio over a period of three months. For example, a company that sold $100 million worth of goods during the third quarter of 2018 had a receivables ratio of 100% because it collected $100 million worth of invoices.
If your accounts receivable ratio is high, it might mean that your company is experiencing growth. However, if your accounts receivable ratio drops too low, it could signal problems. This is especially true if your accounts receivable drop precipitously. You should consider changing your credit policy if your accounts receivable fall below 80% of your total sales.
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Limitations of the accounts receivable turnover ratio
Accounts receivable turnover ratios are used to measure how quickly companies collect money owed to them. This metric is calculated by dividing the total amount of outstanding accounts receivable balance by the average days sales outstanding. While this calculation provides some insight into the speed at which a company collects cash, there are several limitations to relying on this number alone.
The most obvious limitation is that the ratio doesn't tell you anything about profitability. Companies with high amounts of uncollectible debt could still be making a profit. Additionally, the ratio does not account for the fact that older invoices tend to take longer to collect. For example, a company that sells products online might receive payment within 30 days, while a retailer that buys goods wholesale might wait 60 days to receive payment.
A second issue with the ratio is that it does not include any information about customer behavior. If a company has a large volume of slow payers, it could be losing out on potential revenue because of poor credit management. On the flip side, a company could have a small number of slow payers, but those customers may simply be paying late due to a lack of understanding of the terms of sale.
Finally, the ratio doesn't account for seasonal fluctuations in collections. In industries such as retail, where inventory changes frequently, the ratio can become skewed.
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5 tips to improve your accounts receivable (AR) turnover ratio
Accounts receivable (AR) turnover ratio is one of the most important metrics used to measure the effectiveness of your collection efforts. If you want to improve your AR turnover ratio, start by following these five tips.
- Make sure invoices are sent out on time or before the invoice due dates.
- Always state payment terms. For example, "Payment within 5 days of receipt."
- Offer multiple ways to pay – such as credit cards, checks, bank transfers, etc.
- Don't wait until customers are days to weeks behind before starting collections; start collecting immediately.
- Offer discounts for paying in cash. This will help you decrease your costs of accounts payable.
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Track and improve accounts receivable turnover ratio with accounting software
Accounting software helps companies keep track of their finances, including managing their cash flow. This includes tracking how much money customers owe them, and how long it takes to collect those debts. However, many small businesses don't know what steps to take to increase the amount of money collected before the due date. They simply wait for customers to pay up, even though there could be better ways to handle the situation.
An effective accounting software should provide tools to improve your AR turn over ratio. For example, you might want to set up automatic reminders to contact delinquent customers. You can use email, text messages, phone calls, and social media to remind them about their outstanding debt. If you're able to do this, you'll see improved AR turn over ratios because you'll be collecting money faster.
You might also want to consider automating processes like sending invoices, accepting payments, and reconciling bank statements. These tasks can be tedious, but they're necessary to ensure accurate financial records. By automating these processes, you'll save time and energy, while improving accuracy.
A good accounting software will allow your team to identify which customers are having trouble paying their bill. Many times, we assume that our best customers are always going to pay us on time. But sometimes, we discover that some of our most loyal customers aren't as reliable as we thought. In fact, they may actually be struggling to make ends meet. When you spot this problem, you can work to remedy the issue by offering discounts or freebies to encourage them to continue doing business with you.
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Key takeaways for small businesses
- An accounts receivable process improves cash flow by making sure you get paid on time.
- On your balance sheet, accounts receivable is recorded as an asset.
- Businesses that use accrual accounting record accounts receivable as revenue on their income statement.
- If your accounts receivable takes longer than one fiscal year to convert to cash, it’s a long-term asset that’s offset by an “allowance for uncollectible accounts.”
- Accounts payable and debts are liabilities on your balance sheet because it’s money your company owes to others.
- Equity is what’s left over after you’ve subtracted your liabilities from your assets. It’s the net worth of your business.
CHAPTERS
00 The Complete Guide to Improving Your Business with Accounts Receivable
01 Accounts Receivables and Assets Explained
02 Accounts Receivable vs. Accounts Payable: What's the Difference?
03 What Is the Accounts Receivable Process?
04 Setting Up an AR Process; Get Paid Faster & Increase Cash Flow
05 Make it Simple to Receive Payments from Your Customers
