What is Accounts Receivable?
Accounts receivable refers to the amount of money that a business is owed by its customers for goods or services that have been sold but not yet paid for.
This is an important aspect of a business's finances, as it represents money that is expected to be received in the future.
In the United States, accounts receivable are often recorded on a company's balance sheet as an asset.
The amount of accounts receivable that a company has can be an indicator of how well it is managing its cash flow and collecting payments from customers.
Managing accounts receivable is an important part of a business's financial management.
This includes sending out invoices in a timely manner, following up with customers who are late in paying, and possibly using collection agencies or legal action if necessary to recover unpaid debts.
Overall, accounts receivable play a significant role in the financial health of a business and are an important metric for investors and creditors to consider when evaluating a company's performance.
What is the Accounts Receivable Process?
In the US market, the accounts receivable process typically follows a cycle with the following steps:
Sales or Service Delivery:
The first step in the cycle is to make a sale or deliver a service to a customer. This generates an account receivable, which is the amount the customer owes the business for the goods or services provided.
The next step is to create and send an invoice to the customer for the amount owed. The invoice should include details such as the date, the amount due, and the payment terms.
Once the invoice is sent, it needs to be recorded in the accounting system. This ensures that the amount owed by each customer is accurately reflected in the company's books.
When the customer makes a payment, it needs to be processed in the accounting system. This typically involves matching the payment to the corresponding invoice and updating the customer's account.
Regular reconciliation is necessary to ensure that the accounts receivable balance is accurate. This involves comparing the total amount of outstanding receivables to the balance in the accounting system.
In cases where customers haven't paid on time, collections may be necessary. This involves sending reminders, making phone calls, or even enlisting the help of a collection agency to recover the debt.
Bad Debt Write-Off:
If a customer fails to pay even after collections efforts, the account may be written off as a bad debt. This involves removing the outstanding receivable from the accounting system and recognizing the loss as an expense.
Finally, reports are generated to track the performance of the accounts receivable process.
These reports may include aging reports, collection reports, and bad debt reports, among others. The information in these reports can be used to identify areas for improvement and make informed business decisions.
Examples of Accounts Receivable
Accounts receivable financing can get a bit tricky to understand, especially when you are new to the concept or just starting out.
To help you understand better, let’s look at an example of accounts receivable financing.
Let’s assume that a company, Sam Inc., is a manufacturer of widgets. They have just gotten a large order from a company, Ted Corp., for $100,000 worth of widgets. The payment terms state that the customer has 30 days to pay the invoice after they receive the goods.
However, Sam Inc. needs the funds immediately to purchase raw materials for another large order and also needs to pay its employees. They can’t wait 30 days for Ted Corp. to make the payment.
So, Sam Inc. decides to use accounts receivable financing to access immediate cash.
Sam Inc. contacts a financing company that specializes in accounts receivable financing and provides them with a copy of the invoice for $100,000 from Ted Corp.
The financing company reviews and evaluates the invoice to determine whether Sam Inc. is eligible or not. Once they decide that the company is eligible for accounts receivable financing, the financing company provides Sam Inc. with a cash advance of $80,000, which is 80% of the invoice value.
When Ted Corp. pays the invoice in 30 days, the financing company collects the full amount of $100,000. Sam Inc. then repays the $80,000 plus the fees to the financing company.
In this way, Sam Inc. gets immediate access to the funds through which they can purchase the raw materials for the new order and pay their employees without having to wait for Ted Corp. to make its payment.
What are the Three Major Types of Receivables?
Here in the U.S, there are three major types of receivables:
1. Trade Receivables
Trade receivables are where the amounts owed to businesses by their customers for goods or services are sold on credit.
2. Notes Receivables
Notes receivables are where there is a promise to pay the debt, generally in the form of promissory notes, that have been made by the customer or other entities.
3. Other Receivables
Other receivables is a category that includes any other type of receivables that does not fit into the two categories mentioned above. This includes interest receivable or rent receivable.
What are the Four Forms of Receivables Financing in the US?
There are four forms of receivables financing in the U.S, it includes:
Factoring involves businesses selling their outstanding invoices to a third-party financing company, also known as a factoring company, for a fee.
The factoring company then takes the responsibility of collecting payment of the invoices from the customer.
2. Accounts Receivable (AR) Loans
Accounts receivable (AR) loans involve borrowing against a business’ accounts receivable.
In this form of receivables financing, the lender provides cash in advance to the business based on the value of the outstanding invoices.
The business then repays the advance plus fees when the invoices are paid.
3. Asset-Based Lending (ABL)
In asset-based lending (ABL), the lender uses the company’s assets, including accounts receivable, as collateral to secure funding.
This form of receivables financing is also considered to be a type of loan in the U.S.
4. Purchase Order Financing
Purchase order financing is designed in a way that helps businesses fulfill their large purchase orders.
In this form of receivable financing, the lender provides the necessary funds to pay the suppliers.
The lender takes a lien on the purchase order and the related accounts receivable until the payment is received from the customer.
What are the Factors Affecting the Quality of Receivables in the U.S?
In the US, the quality of receivables can be affected by various factors, including:
1. Industry Risks
Industries that are heavily dependent on consumer spending or are subject to regulatory changes are some of the industries that may face higher levels of default risk.
The competition within the industry also is a deciding factor that affects the quality of receivables.
This is because the level of competition in a particular industry can affect the ability of a business to collect payment from its customers, as they are more likely to choose a competitor who is offering more favorable payment options/terms.
3. Payment Terms
The quality of receivables can be highly affected by the length of time allowed for payment to a business’ customers as well as the conditions under which payment is expected.
4. Creditworthiness of the Customer
The payment history and financial history of the customer can have a significant impact on the likelihood of the payment.
5. Economic Conditions
The state of the economy, including consumer confidence and level of unemployment, can also affect the ability of customers to pay their outstanding payments to businesses.
6. Internal Controls
Even the quality of a business’ internal controls and financial systems can impact its ability to accurately track and manage its accounts receivables.
What is the Difference Between Accounts Receivable and Accounts Payable?
Accounts payable financing involves using a third-party lender to pay a business's outstanding bills to its suppliers.
This financing option is essentially a short-term loan that is used to cover the costs of goods and services purchased on credit.
The lender provides the funds to the business to pay off its outstanding bills, and the business pays the lender back over time with interest.
This type of financing can help businesses manage their cash flow and improve their relationships with suppliers.
Accounts receivable financing, on the other hand, involves using a third-party lender to borrow money against outstanding invoices that a business has issued to its customers.
This financing option is also known as invoice financing or factoring.
The lender provides the business with a percentage of the invoice value upfront, and then collects the full amount from the customer when the invoice is due.
The lender charges a fee for this service, which is usually a percentage of the invoice value.
Accounts receivable financing can help businesses improve their cash flow and reduce the risk of non-payment by customers.
Read more about it here.
What is the Difference Between Factoring and Accounts Receivable Financing?
Accounts receivable financing and factoring both use outstanding invoices as collateral for short-term lending, but differ in several ways.
Factoring has higher fees, involves a third-party financing company buying the invoices and collecting payment, and is less confidential, while accounts receivable financing has lower fees, businesses retain responsibility for collecting payment, and is more confidential.
Repayment for factoring is due when the customer pays, while accounts receivable financing is repaid over 6-12 months.
Factoring offers an advance payment of 80%-90%, while accounts receivable financing offers 70%-80%.
Accounts receivable financing can be a useful tool for businesses to improve their cash flow and reduce the risk of non-payment by customers.
By borrowing money against outstanding invoices, businesses can access funds more quickly and efficiently than waiting for customers to pay their bills.
However, it's important to carefully consider the fees and terms associated with this type of financing and ensure that it aligns with the business's financial goals and needs.