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What Is Accounts Receivable?

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What Is Accounts Receivable?

Written by Veronica Ott
Fact-checked by Caitlin Wood

What Is Accounts Receivable?

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Accounts Receivable Business

Accounts receivable is a term that is often thrown around by accountants. The term goes hand in hand with other terminologies such as invoices, collection processes, and revenue. If you’re wondering what accounts receivables are and why they’re so important, you’ve come to the right place. In this article, we will explore what accounts receivables are, why they’re important, and how you can manage them as a business owner. 

What Are Accounts Receivables?

Accounts receivable is the sum of money that customers owe a business for products or services that were provided in the past. Accounts receivables are considered to be an asset because it is money that will be received by the business in the future. 

Do you know the difference between short and long term assets? Find out here.

Why Is It Important to Manage Your Accounts Receivables?

Accounts receivables exist because a business extended a product or service on credit. This means that the client agreed to pay for the product or service in the future. However, sometimes accounts receivables are difficult to collect for an array of reasons. Sometimes it’s as simple as the client is having cash flow problems, other times its because the customer doesn’t want to pay. 

Regardless of the reason, when a business doesn’t collect their accounts receivables, they’re providing a product or service for free. You may be wondering, why would a business provide a product or service on credit with the risk of not being able to collect the money? The answer is, it’s convenient for the client which improves the level of service you’re providing. 

Instead of avoiding using credit entirely, most businesses actively manage their accounts receivables. This means reviewing what’s currently owed, assessing how overdue an owed amount is and communicating with clients to collect payment. The main reason why this is so important is because your cash flow will be impacted if you don’t collect fees for products and services provided. Essentially, you’ll be paying money to provide the product or service with no profit.

Learn how to boost your profits by cutting common business expenses. 

Helpful Measures When Managing Your Accounts Receivables

There are various ratios from the world of accounting that are used to manage accounts receivable. There are three main ratios used to analyze accounts receivable. They are listed below, along with what the ratio communicates. 

  • Average Receivables Turnover Ratio (Net Credit Sales / Average Accounts Receivables). Communicates how many times a company collected their average accounts receivables over a certain period of time. The higher this number is, the better because it means the business has collected their average debt quickly. 
  • Average Number of Days to Collect (365 Days / Accounts Receivable Turnover Ratio). Communicates the number of days between when a credit sale was completed and when the money was received from the customer. The shorter this period is, the better a business is at collecting debt.
  • Receivable-to-Sales Ratio (Accounts Receivables / Sales). Communicates business liquidity and measures how much of a company’s sales happened using credit. A high ratio indicates short term cash flow problems because the credit sales may not be collected quickly enough. 

How To Analyse and Manage Your Accounts Receivables

There are several tricks and tools you can use to effectively analyze your accounts receivables. The larger volume of sales you have, the more important it is that you stay on top of your accounts receivables. Let’s explore these tricks and tools below. 

  • Automation. If you have an accounting system that automatically sends out invoices and tells you when a payment is missed, it will be easier for you to manage. 
  • Policies and Procedures. Many companies have policies around debt collection. For example, when an invoice is 90 days overdue, it’s sent into collections. Or, payment reminders are sent every Friday for overdue invoices. Whatever suits your business best, make a clear policy to stay on top of your accounts receivables. 
  • Use Ratios. By using the ratios listed above, you’ll be able to assess how effective you are at collecting accounts receivables. If you’re not doing great, it’s time to make some changes.

Should you implement a mid-year performance review?

How Accounts Receivables Can Impact Different Parts of a Business

As mentioned, a lack of accounts receivable collections impacts cash flow. Without money coming in, you will eventually run out of cash to pay bills and employees among other expenses. When you start defaulting on payments, your business can only operate for so long. 

Money is the Bloodline of Business

Money truly is the bloodline of a business. Without it, you can’t pay for employee’s time, buy the raw materials you need or pay for your facilities. For these reasons, it’s important to stay on top of your accounts receivables so you don’t run into other issues. 

Business Glossary

Terms
Accounts Payable

Money that is owed in relation to a product or service to a creditor. Because the money is owed to an individual or entity, accounts payable are considered to be an obligation.

Accounts Receivable

Money that is owed in relation to a product or service from a borrower. Because the money is due to an individual or entity, accounts receivable are considered to be an asset.

Appreciation

The increase in an asset’s value over time. Appreciation is often the result of an increase in demand, weakening supply and/or changes in the economy.

Arrears

Money that should have been paid and is now overdue.

Audit

The process of an impartial, independent individual or entity inspecting completed work in relation to a specific framework. Audits are commonly performed on financial statements to ensure that they are accurate, fair and align with accounting rules and regulations.

Balance Sheet

A formal financial statement that communicates the current financial position of a business at a specific point in time. Assets, liabilities and equity are all reflected on a balance sheet as well as net income (or loss) earned over a previous period of time.

Ballon Loan

Unlike regular loans, a balloon loan isn’t fully amortized over a particular period of time. Instead, only part of the loan is amortized over the loan’s term and the remainder of the loan becomes due at the end of the loan’s term. The loan’s term tends to be short and this type of financing is considered to be aggressive. 

Better Business Bureau (BBB)

A non-profit organization that assigns rankings to businesses, charities and non-for-profit corporations. The BBB collects and stores data regarding companies to set rankings. Their goal is to prevent businesses from failing to meet defined standards of operation.

Book Value

The value of an asset on a company’s books. In other words, the value of the asset on the balance sheet.

Broker

A person who buys and sells goods and services on behalf of another person in exchange for a fee.

Budget

A best guess of an individual or entity’s income and expenses for a specific period of time.

Business Credit Report

A detailed report that is meant to provide potential lenders with information to allow them to determine the business’ creditworthiness before extending credit. There is much more information in a business credit report when compared to an individual’s credit report. Business credit reports are generated and regulated by the credit bureau.

Business Credit Score

A number that represents a business’ creditworthiness based on information within the credit report. The credit bureau calculates and regulates business credit scores.

Cash Flow

The cash that comes in and goes out of a business. Cash flow is poor when more cash is going out than in. Cash flow is good when more cash is coming in than out.

Compound Interest

Earned interest that is added to the principal amount when interest for the next period is calculated. In other words, compound interest is interest earned on interest.

Debt Service Coverage Ratio

The ratio of operating income available for use to debt servicing. Debt servicing includes interest, principal and lease payments. The main goal is to determine whether or not a business is producing enough cash to cover their debt obligations.

Deferment

The act of pushing something off to a later time. In terms of finances, this means paying a debt later than when it’s due or creating an arrangement where the customer receives the product or service now but pays later.

Depreciation

The decrease in an asset’s value over time. Depreciation is most commonly a result of wear and tear from use, but can also be a result of a decrease in demand, increasing supply and/or changes in the economy.

Earned Income

Money that is received or receivable resulting from finished, paid work.

Employer Identification Number (EIN)

A number used to identify a business regardless of whether they are a sole proprietorship, partnership, corporation or other non-personal entity. An EIN is the American version of a Canadian business number.

Escrow

Something, such as money, a document or an asset, kept in the custody of a neutral, third party until a specific condition has been met.

Financial Statements

Formal records depicting the financial position and activities of a business, individual or entity. Financial statements are very structured and are subject to rules and regulations. Usually, financial statements include a balance sheet, income statement and statement of cash flows.

Fixed Expense

A cost that does not fluctuate when there is an increase or decrease in business activity, such as sales or production. Examples of fixed expenses include a full-time employee’s salary, rent and insurance, among others.

Gross Profit

The amount of money earned after considering expenses directly related to producing a product or service. Gross profit is typically calculated on a company’s income statement by taking revenue and subtracting cost of goods sold.

Incentive Stock Option (ISO)

A company benefit that gives an employee of that company the right to buy stock shares at a lower price than the fair market value. There is also the added benefit of a tax break on any profits earned from the stock share purchase.

Income Statement

A formal financial statement that communicates the income, expenses and net income (or loss) for a business over a particular period of time. 

Incorporated

The state of being formed into a legal corporation.

Inflation

A general increase in prices of goods and services in addition to a decrease in the purchasing power of a nation’s currency.

Liability

The state of being responsible for something particular. In the business world, this typically refers to legal and financial responsibilities. 

Market Value

The amount that an asset is worth or can be sold for in a particular market place.

Micro-Loan

A small amount of money lent to new businesses with a low-interest rate. Micro-loans are typically issued by individuals as opposed to large lending bodies like banks or credit unions.

Partnership

A type of business where two or more individuals share ownership, pool resources and split responsibility for the company’s operations. Partnerships can be classified as general or limited. 

Profit

The difference between the amount of money earned and the amount of money spent to earn the money.

Retained Earnings

The amount of net income left over after a business has paid out dividends to their shareholders. Often, the retained earnings are used within the business for investment, growth or capital purchase purposes.

Sole Proprietor

An individual who is the only owner of a business known as a sole proprietorship. That individual is entitled to all of the profits after all liabilities and taxes have been paid.

Tax Refund

An amount owed to or received by a taxpayer from the government resulting from taxation. A tax refund typically occurs when an individual has paid more income tax throughout the year than what was owed, has large tax credits or did not earn enough income to be required to pay tax by law.

Tax Return

A legal form which is completed by a taxpayer to determine tax payable to the government or tax receivable from the government. Tax returns require information about the taxpayer, such as annual income, annual expenses, personal information and financial information, to determine the tax asset or liability.

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