Accounts Receivable: Impact on Financial Statements and Best Practices for Management

Introduction

Accounts receivable (AR) refers to the money owed to a business by its customers for goods or services that have been provided but not yet paid for. AR is often considered one of the core current assets of a business, as it represents cash that will eventually be collected. It is important for businesses to understand the impact of accounts receivable on their financial statements, as well as best practices for managing accounts receivable.

Understanding the Impact of Accounts Receivable on Balance Sheets

Accounts receivable are presented on the balance sheet under the category of current assets. According to the Financial Accounting Standards Board (FASB), “current assets are those assets that reasonably can be expected to be realized in cash, sold, or consumed during the normal operating cycle of the business.” This means that accounts receivable is considered a liquid asset, since it is usually collected within a year of being recorded.

When looking at accounts receivable balances on the balance sheet, it’s important to pay attention to the age of the receivables. If receivables are too old, it could indicate a problem with collecting payments from customers. It’s also important to look out for any large, uncollected amounts that may be indicative of bad debt.

Analyzing Accounts Receivable Performance

To evaluate the performance of accounts receivable, businesses typically use two key metrics: accounts receivable turnover and days sales outstanding (DSO). Accounts receivable turnover measures how quickly a business is able to collect payments from customers. It is calculated by dividing total sales by average accounts receivable. A higher accounts receivable turnover ratio indicates better performance, as it suggests that customers are paying more quickly.

Days sales outstanding (DSO) measures the average number of days it takes for a business to collect payments from customers. It is calculated by dividing the total amount of accounts receivable by total net credit sales and multiplying by the number of days in the period. A lower DSO indicates better performance, as it suggests that customers are paying more quickly.

Evaluating Accounts Receivable Ratios

In addition to analyzing accounts receivable turnover and DSO, businesses can also evaluate accounts receivable ratios such as the collection period ratio and the bad debt ratio. The collection period ratio measures the average number of days it takes for a business to collect payments from customers. It is calculated by dividing the total amount of accounts receivable by total net credit sales and multiplying by the number of days in the period. A lower collection period ratio indicates better performance, as it suggests that customers are paying more quickly.

The bad debt ratio measures the percentage of accounts receivable that a business has written off as uncollectible. It is calculated by dividing the total amount of bad debt by the total amount of accounts receivable. A higher bad debt ratio indicates worse performance, as it suggests that customers are not paying their bills on time.

By evaluating these accounts receivable ratios, businesses can gain insight into their performance and determine areas for improvement.

Best Practices for Managing Accounts Receivable

To ensure efficient management of accounts receivable, businesses should implement best practices such as establishing credit policies and procedures, utilizing automated billing and collection systems, and setting payment terms and discounts. Establishing credit policies and procedures helps to ensure that customers are aware of payment terms and the consequences of not meeting them. Utilizing automated billing and collection systems can help streamline the process of sending invoices and collecting payments. And setting payment terms and discounts can incentivize customers to pay sooner.

By implementing these best practices, businesses can ensure efficient management of accounts receivable and maintain healthy cash flow.

Conclusion

Accounts receivable is an important component of a business’ financial statements, and understanding how it impacts the balance sheet is critical for businesses. By analyzing accounts receivable performance metrics such as accounts receivable turnover and days sales outstanding, businesses can gain insight into their performance and identify areas for improvement. Additionally, businesses should implement best practices such as establishing credit policies and procedures, utilizing automated billing and collection systems, and setting payment terms and discounts to ensure efficient management of accounts receivable and maintain healthy cash flow.

For further resources on understanding and managing accounts receivable, check out The Balance Small Business and Investopedia.