If you know a thing or two about running a business, chances are you already know what accounts receivables (AR) and accounts payables (AP) are. If you don’t, fear not! This article will guide you through the basics of AR and AP, what they are, why they’re important, and some things you should keep in mind when recording transactions related to them.
What is accounts receivable and accounts payable?
As a business, you will often have to allow your customer to purchase your product or service on credit, rather than collect payments immediately. This allows customers some breathing space to pay you, and also removes transaction costs, and the hassle of collecting payments from customers every time.
Let’s assume you’ve given your customer a certain amount of time to pay you $10,000 for a product or service that you’ve delivered to them. This credit of $10,000 is recorded as your account receivable (AR). Accounts receivable is therefore the sum of money your customer owes you for goods or services you delivered to them or that they used, which they have not yet paid for.
Now, let’s say you purchase $10,000 worth of material from a vendor, and the vendor gives you a certain amount of time to pay. This $10,000 is recorded as your accounts payable (AP). Accounts Payable is the sum of money you owe to a vendor or a seller for purchasing their product or service, for which you have not yet paid.
In other words, AR refers to the outstanding invoices your business has or the money your customers owe you, while AP refers to the outstanding bills your business has or the money you owe to others.
Why are AR and AP important?
Keeping track of your ARs and APs helps you understand the health of your business finance. Regularly maintaining records ensures that you are up to date with who owes you money or who you owe money to, allowing you to be fully aware of your financial situation. This allows you to know how much money you have at your disposal, and how much money you will be paying for all your bills.
AR is important as they indicate that a business has successfully obtained orders and that it can expect an inflow of funds. In the world of accounting and balance sheets, AR is considered an asset, as they can be turned into cash in the future. They are also important if you have investors or if you are considering borrowing money. Your AR tells you how much money your business will be making or how much you have at your disposal, which is vital to lenders’ or investors’ perception of your business .
AR can also be used for short-term financing in case of cash flow problems. You can sell outstanding invoices to third-parties for a percentage of the original invoice amount, bringing guaranteed funds to finance your short-term cash flow needs. This particular process is called invoice factoring.
AR, being considered assets, are also a measure of a company’s liquidity. Liquidity means how quickly you can turn your business assets into cash. This allows you to easily make changes in purchases or sales if required, such as to your pricing, in case of an emergency.
Managing your AP is crucial to making sure your business doesn’t have to deal with any issues caused by missed or delayed payments, overdue bills, late fees etc.
Delayed payments and overdue bills can also lead to your vendor or seller losing trust in you and your business’s ability to pay for their products or services. This could mean your vendor will not deliver your required goods or services on time.
Pending AP is an indicator of your business’s inability to pay off bills on time or insufficient cash flow, and are recorded as liabilities in a balance sheet, as funds are expected to leave the company.
This can also mean that when you need the money most, you will not have any left as it is tied up in making long pending payments.
What does recording AR and AP involve?
As mentioned earlier, accounts receivables are recorded under assets, while accounts payables are recorded under liabilities in the balance sheet. While managing APs is simply a matter of making payments, and recording due and completed payments, managing your AR requires some extra effort on your part.
Handling your accounts receivables involves several steps from the moment you send an invoice to your customer, to the moment you update your accounts.
1) Keeping track of invoices/bills: In order to provide customers credit to purchase your product or service, and to keep record of the purchase, you will need to send customers an invoice. This should have the details of the good or service being sold, the date of purchase, the payable amount, and the timeframe within which your customer has to pay.
2) Setting reminders: Setting reminders for your customer to make payments, and for yourself to pay you bills is crucial to making sure no payment is overdue. Piled up AR or AP is never an indicator of a smoothly running business. The longer it takes to make the payment, the longer your accounts receivable stays open, the less chance you have of getting paid.
3) Making/Receiving payments: Making transactions is the crux of your business. Paying your bills and collecting payments from customers is how your business runs. This requires you to have a grasp of your finances, and see who owes you money and whom you owe money to.
4) Updating accounts: Just as crucial is making sure to record all payments due or received in your accounts. This ensures you have a clear idea of your cash flow.
Online accounting - the way to go:
Both AR and AP are important aspects of your business’ functioning. Managing them however can be a bit of a hassle. Investing in an online accounting system can help with several processes involved with your AR and AP, including:
1) Invoices and bills: Managing all your bills and invoices can be difficult. Keeping track of your invoices and bills is simpler when it’s all in one convenient location. You can send invoices or record bills for every transaction you make, and schedule them to be sent automatically on a later date.
2) Reminders: It’s easy for your customer to forget about a pending payment, just as easy it is for you to forget a payment you owe to a vendor. With an accounting system, you can send reminders to your customers, as well as set reminders for yourself when it is time to pay.
3) Payments: Most accounting systems integrate with several payment service providers to ensure you give your customer the benefit of choosing whichever payment method they prefer. This can prove to be very important when it comes to ensuring payments are made on time, every time.
4) Reports: Several accounting systems give you access to automatically generated financial reports for all the transactions going in and out of your business.This helps you have an overall understanding of how your business is doing, and can help make some important decisions.
Things to keep in mind
As a business owner, there are a couple of things you should keep in mind when working with AR and AP:
1) Set appropriate terms for your customers: The terms you set for your customer to make payments varies depending on several factors, what kind of business you run, or which industry you belong to. This includes how soon you want the payment, how much credit you are willing to extend to your customer, or how much the amount is. Setting terms which are financially beneficial for you, but fair to your customer is important to have a healthy relationship, and consequently, important for your cashflow.
2) Ensure invoices get cleared: The longer it takes to clear a pending invoice, the less chance you have of getting paid. Ensure that you collect payments from your customers for invoiced amounts as soon as you can. While AR are assets and are indicative of incoming revenue, you need to make sure they get converted to cash and that you get paid for them. High AR can lead to cash flow problems. Overdue invoices can lead to your business experiencing a negative cashflow, where all your funds go towards paying your bills.
3) Pay off bills as and when they’re due: Pending AP in your books can indicate your business’ inability to clear your bills. Taking too long to clear bills and make payments not only results in late fees, and penalties, it can be damaging to your relationship with your vendor or seller. The longer an AP sits in your account, the higher the chances of investors, banks, and vendors losing trust in your business.
4) Maintain clear records and update them regularly: Keeping a clear record of your income and expenses is crucial to ensuring you run a succesful business. Doing so helps your produce good financial statements, which are important when it comes to official or legal purposes, or simply for monitoring your business’ cashflow.
Run your business smoothly
In summary, managing your AR and AP is paramount to running your business. Monitoring and clearing them as and when they’re due ensures your business does not suffer any cashflow problems. Quite often, a business’ value is determined by its accounts receivable-to-sales ratio, which is essentially your accounts receivables divided by your sales. This value determines how many sales have not been completed because of outstanding and overdue invoices, and helps banks and investors determine the ease with which you are able to collect payments from customers. This value helps you, as well as banks and investors, if you are considering borrowing money, to determine whether your business can smoothly without running into any cash crunch in the immediate future. Having a control over your AR and AP and having an up-to-date picture of their status will help you plan ahead (like maybe business expansion plans or adding a new line of product or service).