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Accounts receivable

Accounts receivable is money that a customer owes to a company for goods or services sold on credit.

Expanded Definition

Accounts receivable is the amount of money that is owed to the company after the company extends the customer credit. For instance, a distributor may deliver napkins and plastic utensils to a fast food company and be paid for that delivery in the future. When the delivery happens, the revenue is "recognized." The goods have been delivered and there is a high expectation of payment. The amount owed is recorded in the accounts payable portion of the balance sheet. When it is paid, then the accounts payable account is reduced, and the cash account is increased. When that cash is received, there is no further recognition of revenue as that had been done already.

In other words, sales are paid for either by cash or credit extended by the company to the customer. In either event, the revenue is recognized. Then, when the payment is received on the account receivable, no additional revenue is recorded.

Generally, payment on accounts receivable is expected within one year. However, in most businesses, payment for goods sold on credit is typically received within 30-90 days of sale. This account is listed as a current asset on the company's balance sheet. Late payments can be charged interest (although in practice this is often waived if the customer is usually a prompt payer, in the spirit of maintaining good customer relations). Accounts receivable also often do not have a 100% success rate in collection, as the company extending the line of credit, like all creditors, takes the risk that the customer will have the means and intent to pay what the customer owes. To counter some of this risk, businesses usually own extend lines of credit to their biggest, most frequent and most reliable customers.

The reverse situation when a company owes money to its vendors, suppliers etc is called accounts payable

For investors checking a company's accounts receivable can be way to predict a company's own future financial health . If an investor sees a rapidly growing accounts receivable relative to sales, than that could be a red flag indicating the company could have trouble paying it's own bills. After all it is hard to pay your own bills when you yourself have not been paid! The company with a disproportionately growing AR will likely experience hiccups in their cash conversion cycle which would hamper their efficiency (as evidenced by metrics such return on equity, return on assets or return on invested capital. In the most extreme cases a company may be forced to take on additional debt to meet its obligations if it can not collect its AR in a timely manner.

Another indicator to watch is Days Sales Outstanding. This is a measure of how long it takes to collect accounts receivable. It is calculated by taking the average accounts receivable balance (beginning + ending, divided by two), dividing that by the revenue generated for the time period, and multiplying that by the number of days in the period (91 for a quarter, 365 for a year). If this number starts to climb over time, it could mean that the company is having a more difficult time collecting on what is owed to it. This might lead to more generous credit terms and could lead to a higher level of uncollectable accounts receivable (which leads to lower revenue and net income). Days Sales Outstanding is one component of the cash conversion cycle.


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