Accounts receivable (AR) is an accounting term that is used to describe amounts owed by customers at a certain point in time. It is a required disclosure under US GAAP and is a product of the accrual method of accounting. Business leaders closely monitor and manage accounts receivable balances because they effectively represent credit extended to customers.
In this post, we will cover what AR is, how to understand it, its impact on FP&A, and financial reporting.
What is Accounts Receivable (AR)?
Accounts Receivable (AR) is an accounting term used to describe amounts due from customers for goods and services rendered. It is a result of the accrual method of accounting, which requires that businesses record revenue and expenses in the period they are earned, not necessarily received.
Thus, the timing differences created between when a business earns revenue and receives revenue create a balance due from customers. This balance of unreceived payments is coined Accounts Receivable and is represented on the balance sheet as an asset.
Typically, Accounts Receivable (AR) is considered to be “short-term” in nature, resulting from small timing differences in the revenue cycle. The assumption is also strengthened by the fact that many businesses have short-term payment terms, often 90 days or less after receipt.
Understanding Accounts Receivable
Astute managers are very concerned with managing accounts receivable as it has a direct impact on actual cash flows. Amounts that go uncollected for long periods of time can be viewed as interest-free loans to customers. Therefore it is very important for businesses to effectively and proactively manage amounts owed to them.
Large Accounts Receivable balances are generally considered bad, especially if a business is heavily dependent on physical cash to sustain its operations. This leads many businesses to seek out favorable payment terms with vendors and suppliers in exchange for large and regular purchases.
By collecting amounts owed to them before they are required to repay vendors, businesses can effectively use their accounts receivable to satisfy their accounts payable.
AR is also used in the Accounts Receivable Turnover calculation, which is a financial ratio that is used to identify how efficient a business is at collecting credit that it has extended to customers.
How Accounts Receivables Impact FP&A
FP&A and corporate finance professionals are keen on the impact that accounts receivables have on both cash flows and valuations.
Analysts use accounts receivable to help forecast a business’s ability to generate cash flows. In turn, cash flows are used in a variety of ways throughout the finance sector. By identifying a business’s cash flows, analysts can determine if management is efficiently managing its assets. Additionally, it reveals the business’s ability to operate as a going concern and to create free cash flow that can be used to expand or pay shareholders.
Analysts also use accounts receivable balances and the subsequent turnover ratio to gauge a business’s ability to efficiently manage the credit it extends to its customers.
Because businesses often negotiate favorable credit terms with customers to encourage faster payments, FP&A analysts work to identify favorable repayment and collections strategies to maximize cash flow.
Accounts Receivable and Financial Reporting
Businesses that adopt the accrual method of accounting must report their accounts receivable balance as of the reporting date according to US GAAP. Therefore, it is presented on the balance sheet as a current asset.
Additionally, the change in accounts receivable over the period is presented in the statement of cash flows. If a business reduces its accounts receivable over the period, the statement of cash flows will show a positive number and visa-versa.