Is Accounts Receivable an Asset

What is Accounts Receivable?

Accounts receivables are the money that is owed to the company by its customers for goods and services that have been delivered but not yet paid. 

When businesses extend credit to customers, they record this amount as accounts receivable, anticipating that it will be collected in the future. Simply speaking, when a company sells a product or service, the amount to be paid later by the customer is recorded as an accounts receivable.

A business encourages accounts receivables to promote sales. The inclusion of accounts receivable in current assets helps assess a company's liquidity. 

An increasing amount of accounts receivables can mean that the business has significant sales on credit. If these credit sales are collected appropriately, it can enhance the overall cash flows and operational efficiency. These receivables can be used as collateral for loans and other financing options and enhances their liquidity position.

While accounts receivable indicate potential revenue, it is important to note that they do not count as actual revenue until payment is received.

How Does Accounts Receivable Work?

Let's consider an example. Imagine you run a small furniture business. You sell a table to a customer for $1,000, but the customer promises to pay in 30 days. 

Instead of receiving cash immediately, you now have an IOU—an accounts receivable—that sits on your balance sheet until the customer pays. Once the payment is made, the account receivable is converted into cash.

Accounts receivable plays a vital role in a company's liquidity and cash flow management. It allows businesses to offer credit to their customers, which can increase sales, but it also comes with risks and challenges that need to be managed effectively.

Why Accounts Receivable is Considered an Asset

Accounts receivable are classified as current assets because they represent money owed to the company that is expected to be collected within one year. This makes it a crucial component of total current assets.

Apart from the fact that AR is collectible within a year or an operating cycle, the following factors should be considered when asking why AR is considered an asset:

1. Future Economic Benefit: Accounts receivable represents a future cash inflow. The expectation is that these amounts will eventually be converted into cash, making them a resource that provides economic value to the business.
2. Tangible Asset Status: Accounts receivable are often regarded as tangible assets since they have a measurable value and represent a legal obligation from customers to pay.
3. Importance in Cash Flow Management: For businesses, accounts receivable play a crucial role in managing cash flow. When companies offer credit terms, they may not receive immediate payment for their products or services, but the promise of future cash allows them to maintain operations, invest, or meet short-term obligations. This makes AR a vital asset for maintaining liquidity.

Impact of Accounts Receivable on Financial Statements

Account receivables are current assets that are listed on the balance sheet under the asset section. It represents the money owed to the company resulting from a sales transaction without any payment. In the following paragraphs, we will understand the impact of AR across financial statements.

Accounts Receivable Turnover Ratio

A key metric related to accounts receivable is the accounts receivable turnover ratio. The AR turnover ratio assesses how efficiently a company collects its receivables. We can use the following formula for calculating the AR turnover ratio:

Accounts Receivable Turnover = Net Credit Sales / Average Accounts Receivable

A high turnover ratio provides insights into how the company collects its receivables. Are they collecting them quickly? On the other hand, a low turnover ratio may signal collection challenges. Are they collecting them slowly?

Days Sales Outstanding (DSO)

Another critical measure is days sales outstanding (DSO). DSO calculates the average number of days it takes to collect accounts receivable. 

DSO = Accounts Receivable / Total Credit Sales × Number of Days

A lower DSO is preferable because it means the company is converting receivables into cash more quickly.

Accounts Receivables in Working Capital

Working capital is the difference between the operating current assets and liabilities, where they form an integral part of the current assets, and working capital is the driving force. They have a direct impact on the liquidity and short-term debt management abilities.

Working Capital = (Accounts Receivables + Inventory + Prepaid Expenses) - (Accounts Payables + Unaccrued Current Liabilities)

Effective management of accounts receivables can greatly improve an organization's operational and financial stability.

Best Practices for Managing Accounts Receivable

Companies should adopt some of the best practices related to AR to ensure they are a valuable asset to them.

Some of the best practices are briefly discussed below:

1. Credit Policy and Terms: Businesses should be clear in their credit policies that outline the criteria for qualifying for a credit. Apart from this, payment terms and consequences of late payments should also be listed. Apart from this, incentives for early payments like discounts.
2. Regular Monitoring: Keep an eye on outstanding receivables. A well-organized aging schedule helps track how long each invoice has been outstanding, allowing companies to act quickly on overdue accounts.
3. Automate the Process: Use accounting software that automates invoicing and tracking. Automation helps ensure that invoices are sent promptly and follow-up actions are taken when payments are overdue.
4. Communicate with Customers: Maintain regular communication with customers to ensure they are aware of their outstanding balances. Friendly reminders can prevent misunderstandings and improve collection rates.

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

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