Understanding Accounts Receivable: Definition and Ratios

Understanding Accounts Receivable: Definition and Ratios

Depending on your business, you might offer customers some flexibility on their payments. For example, you may accept cash, credit card, and mobile payments. You may even allow customers to pay at a later date for a service you’ve already provided them.

If you have just a few customers, you may find it easy to know how much you’re owed at any given time. However, as your customer base grows, you may not remember all the payments that are outstanding. It’s important to keep track of every transaction, including how much your customers owe your business.

Businesses track the money that customers owe them through accounts receivable (AR) balance sheet entries, which accounts receivable accounting shows as debit journal entries. Whether you’re running a business or thinking of becoming a freelance accountant, understanding the concept of accounts receivable is essential.

In this article, we dive deeper into what accounts receivable are, why they’re important for cash flow, and what the risks of a high AR balance are.

What are accounts receivable?

Selling your goods or services to a customer and allowing them to pay at a later date is known as extending a line of credit or making a credit sale. The balance owed to you creates a liability for the customer; however, for your business, it’s an asset known as an account receivable.

Accounts receivable are documented through outstanding invoices, which you, as seller, are responsible for issuing to the customer. This unpaid invoice describes the sale of goods or services, the total amount the customer owes you, and the due date for the payment.

Businesses record receivables as current assets on their balance sheets since customers are legally obligated to pay the debt. Typically, businesses operate on a net 30 basis, which means that customers are expected to clear their payment within 30 days of receiving the invoice. While net 30 is the most common,  some industries use net 60 or net 90.

Whatever payment terms you define, from the time you generate the unpaid invoice until the time you receive payment, the balance needs to be included as an accounts receivable journal entry.

What are the main accounts receivable ratios?

Accounts receivable play a key role in assessing the financial health of your business. Using accounts receivable to calculate ratios can be helpful for tracking business performance.

Consider these three important ratios that incorporate accounts receivable:

Accounts receivable turnover ratio

The accounts receivable turnover ratio measures how efficiently your company is collecting payments owed. A lower ratio implies that your business is operating more efficiently, specifically in getting timely payment of debt. The formula to calculate the accounts receivable turnover ratio is:

Accounts receivable turnover = Net credit sales/Average accounts receivable

The accounts receivable turnover ratio is also known as the “receivable turnover” or “debtors turnover” ratio.

Current ratio

The current ratio helps you assess your company’s liquidity or the ability to pay short-term debts using available cash and other liquid assets that can be converted into cash within a year.

The formula to determine the current ratio is:

Working capital ratio = Current assets/Current liabilities

This ratio measures your company’s current assets compared to its current liabilities. Current assets include accounts receivable, cash, and securities. Current liabilities include accounts payable, taxes payable, and short-term debts.

While the acceptable range of current ratios varies across industries, a ratio between 1.5 and 3 is typically considered financially healthy. A ratio lower than 1 could indicate potential concerns for liquidity problems from irregularities and defaults. In contrast, a ratio over 3 may suggest that your company isn’t using its current assets efficiently or managing its working capital properly.

Days sales outstanding (DSO)

Days sales outstanding (DSO) is the average period of time it takes for your company to receive payment for goods or services sold to your customers. This metric is usually calculated on a monthly, quarterly, or annual basis. DSO can be a good way to  monitor cash flow and indicate problems.  

The formula to measure days sales outstanding is:

Days sales outstanding (DSO) = Accounts receivable for a given period/Total credit sales x Number of days in the period

A low DSO number means you’re getting timely payments from customers. A high DSO number may suggest potential cash flow issues, meaning your company is experiencing difficulty converting credit sales into cash.

In other words, time spent waiting to be paid reduces the value of your business.

What is the difference between accounts payable and accounts receivable?

Accounts payable are the opposite of accounts receivable. While accounts receivable represent the balance owed by customers to your company, accounts payable generally include short-term debt owed by your company to suppliers or other businesses.

So, accounts payable are listed under current liabilities on your company’s balance sheet, whereas accounts receivable are listed under current assets.

What is the impact of an accounts receivable balance on cash flow?

Accounts receivable are used to track cash flow and working capital. When your company has an accounts receivable balance, you have not received a portion of revenue as a cash payment yet. A large accounts receivable balance can negatively impact cash flow, thus impacting the flexibility of your business.

Analysts often evaluate accounts receivable in the context of turnover to measure how often your company has collected its payments owed during an accounting period. Additionally, since accounts receivable are recorded as current assets, they also help measure your company’s liquidity.

How can you maintain a low accounts receivable balance?

Maintaining a low accounts receivable balance indicates that your customers are paying you back on time, which is good for the health of your business. Here are ways to encourage early payments and ensure a low accounts receivable balance:

  • Penalize customers who don’t pay the amount owed on time. You can do this by charging interest or late fees for customers who regularly default on credit terms.
  • Offer customer discounts for paying faster. Discounts and other benefits provide good incentives to customers to pay you on time or even before the due date. This customer reward could also help improve brand loyalty.
  • Use a receivable accounts financing service. Getting a factoring company or a collection agency to do the job for you can be one way to ensure payment of at least some part of the amount due. However, these services often take a huge cut of the collectible amount, so they might be better left as a last resort.
  • Have an allowance for doubtful accounts. Registering an allowance for doubtful accounts shows that you anticipate that some asset account balances won’t be received (even before knowing the specific amount). This, in turn, reduces accounts receivable and writes off account balances that you’re unable to collect.

What are the risks from having a high accounts receivable balance?

A high account receivable balance makes you susceptible to several market risks, including:

  • You have uncollected debt. If your customers don’t pay you what they owe, you may need to incur collection costs or accept a bad debt expense. Depending on the path taken, your assets are reduced by the collection costs or the full amount of the debt.
  • You require on-hand cash. While the amount of money that customers owe you may look like a positive on your income statement, your business also requires a steady cash flow to manage your real-time needs. These short-term assets “on the books” can quickly turn into long-term liquidity problems if you frequently struggle to collect payments from customers.

How to stay on top of your financial accounts

Accounts receivable are integral to your cash conversion cycle and the continued functioning of your business. Having a healthy business requires that you stay on top of your company’s financial statements, including tracking accounts receivable closely.

We recommend getting experts to help you effectively track all of your company’s transactions. Hiring the best professional freelance accountants on Upwork is simple, cost-effective, and fast. As a small business owner, you need to ensure your business is making the best financial decisions so you not only survive, but thrive.

Are you an independent accountant and believe you can help business owners stay on top of their financial statements? Apply for some of the many accounting jobs available on Upwork and develop successful relationships that can propel your career forward.


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Understanding Accounts Receivable: Definition and Ratios
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