What does accounts receivable mean and how does it work?

Many businesses offer credit. For instance, customers may buy your goods now and pay later, or you may perform a service for your clients before issuing an invoice.

When it comes to bookkeeping, these goods or services on credit are recorded as ‘Accounts Receivable’ – money that’s due to you.

Keeping on top of your accounts receivable is important. It helps you manage your cash flow by understanding what you’re owed and when – and also helps you plan around frustrating late-payers and non-payers.

What is accounts receivable?

Accounts receivable – sometimes called trade receivable – is any money that your customers or clients owe you for a service or product they bought on credit.

This money can be from goods they put on their store accounts, or from any unpaid invoices for services. It’s called accounts receivable because it’s money you have the legal right to receive in your revenue account.

Accounts receivable isn’t reported on your income statement, but you will record it in your trial balance and balance sheet – a helpful financial statement for year-end reporting and getting a full picture of your business’s net worth.

What’s the difference between accounts payable and accounts receivable?

Unlike accounts receivable, where clients or customers owe you money, accounts payable is when you owe someone money, e.g. your suppliers.

It’s called accounts payable since it’s money you’re due to pay. Accounts payable is considered a liability and credit, so will go under current or short-term liabilities on your balance sheet.

Accounts payable are funds typically related to goods or services used, which don’t carry interest. Liabilities that have interest, like a bank loan, wouldn’t fall under accounts payable.

What’s the difference between receivables, trade receivables and non-trade receivables?

Receivables include any money owed to your company.

However, within this, there are two sub-categories:

• Trade receivables – These include all money owed to you as a direct result of the goods or services you provided (hence the name ‘trade’).
• Non-trade receivables – Sometimes, someone owes you money not related to your product or service. For example, you might get an insurance reimbursement or tax refund. These are recorded as non-trade or other receivables.

What is the accounts receivable process?

Here’s an example of how accounts receivable works. Let’s say you run a plumbing business.

1. On 1 April, you fix a boiler
2. On 3 April, the job is complete and you send an invoice to the customer, giving them 30 days to pay the balance due
3. From 1 April until the customer pays, you have an account receivable
4. In your trial balance, you’ll record this as a debit in your accounts receivable and credit in your cash account
5. On your balance sheet, you’ll record this under current assets -> accounts receivable
6. Once the customer has paid, you’ll credit the accounts receivable on your trial balance and debit your cash account. And on the balance sheet, you’ll remove the amount from accounts receivable and add it to your cash total (whatever is left of it).

If you keep on top of your accounts receivable, you’ll soon pick up patterns around how your customers or clients pay.

You might notice some clients always take longer than 30 days to make payments. Knowing this will help you plan ahead or change your processes to better manage your cash flow and operate more flexibly.

Is accounts receivable debit or credit?

The golden rule in accounting is that debit means assets (something you own or are due to own) and credit means liabilities (something you owe).

On a balance sheet, accounts receivable is always recorded as an asset, hence a debit, because it’s money due to you soon that you’ll own and benefit from when it arrives.

Accounts receivable is also listed as one of the first, or current, assets on your balance sheet, since payment is expected in the short-term (i.e. in one year or less).

On a trial balance, accounts receivable is a debit until the customer pays. Once the customer has paid, you’ll credit accounts receivable and debit your cash account, since the money is now in your bank and no longer owed to you.

The ending balance of accounts receivable on your trial balance is usually a debit.

What happens if my clients or customers don’t pay?

It’s not uncommon for certain customers or clients to pay their accounts or invoices late. Sometimes, they end up not paying at all. When the sale or service terms aren’t honoured, this causes a cash flow hiccup.

For this reason, accountants often suggest including an ‘Allowance for Doubtful Accounts’ on your balance sheet, under accounts receivable. This figure will be an estimate of how much of your accounts receivable you think you’re unlikely to recover.

To help you estimate this figure, you can use what’s called the ‘aging of accounts receivable’ system and track payment behaviour over time. Most accounting software already includes this as a standard feature.

This system sorts your accounts receivable by customer or client. It records when each invoice was issued and when it was paid, usually in intervals of 30 days, to look something like this:

Over time, this will give you a general idea of when your accounts receivable is usually paid.

What is a typical accounts receivable collection period?

Your collection period depends on your business type, size and cash flow needs. If you’re a smaller business, or have a lot of operating costs, you may need payments for accounts receivable quicker.

Most businesses opt for a payment window of between 10 and 30 days from receipt of invoice.

Some companies, depending on their type, ask for a 50% deposit upfront before doing any work, so that the risk of late or non-payment is lower.

Monitoring your aging of accounts receivable can help you settle on the best payment window.

Whatever you decide, make sure the terms are clear to your clients and customers on quotes, contracts and invoices.

What is accounts receivable financing?

Some companies battle to maintain healthy levels of working capital.

Either they struggle collecting payments or have long operating cycles (e.g. projects that take over a year to complete and get paid for).

In these instances, and to ensure their business isn’t jeopardised, they might apply for accounts receivable financing.

Accounts receivable financing lets companies sell their outstanding invoices to banks or other third party funders in exchange for immediate payment.

You’ll then repay the balance over an agreed time with added interest or fees.

There are two main types of this financing:

• Traditional factoring: Here, you sell your full accounts receivable to a funder or ‘factor’ that pays only a percentage of the total upfront (up to 90 per cent, but usually between 70 and 80 per cent), minus processing fees. The remaining balance is then paid to you once the customers or clients have paid their invoices – and the funder is responsible for collecting these payments. Traditional factoring is recorded on your balance sheet as debt.
• Selective receivables finance: Here, you can choose which receivables you’d like to sell for early payment, and the funder will pay the full amount of each upfront. Rates are often more competitive, the funders are less involved with the customers or clients, and this agreement is not recorded on your balance sheet as debt.

The advantage of this financing model is that you can access working capital quickly, without needing any collateral or giving up any business ownership.

The disadvantage is that you’ll pay interest and fees which, depending on the rate, can be more costly than other financing options.

Qualified accountants can help you make important decisions around accounts receivable, including collection windows, financing and factoring.

They can also help you accurately record your accounts receivable on your balance sheet.

It’s worth getting in touch with one to ensure you’re always on top of your cash flow.

Get expert financial advice

Understanding and managing accounts receivable is crucial for maintaining a healthy cash flow and ensuring the smooth operation of your business.

By staying on top of invoices, recognising the difference between trade and non-trade receivables, and using effective collection practices, you can mitigate risks and optimise your financial processes. 

Keeping a close eye on these elements will help you manage your cash flow effectively and set your business up for success.

Let Unbiased match you with an accountant who can help streamline your accounts receivable management and provide tailored advice to keep your business’s finances in top shape.