Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Accounts Receivable

What it is:

Accounts receivable is an important factor in a company's working capital. If it's too high, the company may be lax in collecting what's owed too it and may soon be struggling to find the cash to pay the bills; if it's too low, the company may be unwisely harming customer relationships or not offering competitive payment terms. In general, accounts receivable leciels correspond to changes in sales levels.

Companies can sometimes use their receivables as collateral for borrowing money. The level of accounts receivable also affects several important financial-performance measures, including working capital, days payable, the current ratio and others.

It is important to note that uncollectible receivables do not qualify as assets (these uncollectible amounts are reclassified to the allowance for doubtful accounts, which is essentially a reduction in receivables); thus, companies usually allow only creditworthy customers to pay days, weeks or even months after they've received the company's services or goods. Sometimes companies sell their receivables for cents on the dollar to other companies that focus solely on collecting the owed amounts.

How it works (Example):

Let's assume that Company XYZ sells $1 million of widget parts to a widget manufacturer and gives that customer 60 days to pay for those parts. Once Company XYZ receives the order and/or sends the parts and/or sends the customer an invoice, it will decrease its inventory account by $1 million and increase its accounts receivable by $1 million. When 60 days has passed and Company XYZ is paid, it will increase cash by $1 million and reduce its accounts receivable by $1 million.

A/R is an asset, and as such, it appears on the balance sheet. In particular, A/R is a current asset, meaning that the amount owed is expected to be received within the next 12 months.

When accounts receivable go down, this is considered a source of cash on the company's cash flow statement, and as such, it increases the company's working capital (defined as current assets minus current liabilities). When accounts receivable goes up, this is considered a use of cash on the company's cash flow statement because the company is "stretching out" the time it takes to receive money owed to it and thus is using cash more quickly.
 

Why it Matters:

Accounts receivable (A/R) are amounts owed by customers for goods and services a company allowed the customer to purchase on credit.