When you run a small business, you work with all sorts of assets, debts, and liabilities that you may have never encountered before. You might have:
- Current assets—things like cash (or cash equivalents) and inventory
- Fixed assets like machines and real estate
- Operating assets like cash and patents
But one item in particular that can often be confusing for the entrepreneur and his/her team is accounts receivable. Are they an asset or a liability? A benefit or a debit? Are they a good thing or a bad thing?
Let’s clear one thing up for starters: Accounts receivable are an asset.
And they are (mostly) a good thing. They’re a current asset and a benefit to the financial health of your business. In fact, as we shall see, accounts receivable are so much a tangible, real, valuable business asset that you can actually sell them (should you so choose).
So what are they exactly? And how and why are they such a great financial part of your asset accounts? Let’s find out!
What are Accounts Receivable?
Accounts receivable are the people, businesses, and accounts that have bought goods from you but haven’t paid for them yet. In short, they’re the entities you’ve extended a credit to.
Here’s how they work: Not everyone who frequents your business pays upon delivery of goods or services, you know that. Sure, some do, many do in fact, but there is also a high percentage of customers in any business who get the goods first and pay later—debtors as it were.
When that happens, their debt to your small business is called a “receivable” or, possibly, a “note receivable” on your financial statements.
The cash payment on that account has yet to be received, hence it is an “account receivable.” Many such accounts are called your “accounts receivable” on your company’s balance sheet. (Note: You wouldn't record accounts receivable on your income statement, however, because those only show revenue and expenses.)
In other words, accounts receivable are money owed to you by customers for items or services already rendered to them. For example:
- If you provided a service for a client but they haven't paid yet, that is an account receivable.
- Or, say that you offer extended time to someone to pay for an expensive product. That, too, is an account receivable.
- If you invoice customers at the end of each month, those collectively are accounts receivable.
For the record, let’s be clear that if your company is the one that owes the money—say, to a vendor for inventory already delivered—that is an “accounts payable.” That is not an asset. It is a debt and liability, and an article and discussion for a different day.
Are Accounts Receivable an Asset?
When someone legally owes your business money for services rendered, although the debt is intangible, it is nevertheless a tangible asset. If someone personally owed you $500, would you or your CPA not consider that IOU an asset on your Excel spreadsheet? You would.
So yes, accounts receivable are assets.
The Benefits of Having Accounts Receivable
So why might small businesses choose to rack up their accounts receivable? Here are all the top ways accounts receivable can benefit you:
Customers Like Accounts Receivable
Customers like buying on credit (and thereby allowing a business to create an account receivable) because it:
- Allows them to buy, and buy now
- Makes it easier to buy
- Creates goodwill. Customers like the courtesy and convenience of credit
Accounts Receivable Earn You Interest
You do not just give people extra time to pay for your products without expecting something back in return, right? And that something back is money. While we all want to be paid in full and on time, one benefit of extending credit is that the longer it takes people to pay, the more you will make in interest payments. (Hey, the entire credit card industry is built on this fact, so it must not be insignificant!)
Accounts Receivable Can Help You Grow Your Business
As we’ve been saying, accounts receivable are a cash asset on your balance sheet.
Specifically, because your accounts receivable will (hopefully) soon be converting into income, they are considered a benefit to a business's financial accounts. This helps when trying to get investors or even a loan to grow your business—as it shows you’ll be able to pay off your debts.
You Can Sell Your Accounts Receivable
Have you ever heard of factoring? If you want to understand just how valuable an asset your accounts receivable are, just take a look at factoring. Factoring is an entire industry that is dedicated to the buying and selling of accounts receivable.
Read that last sentence again.
Accounts receivable are such a good asset that a company called a factor will pay you for all or part of your accounts receivable. That can give you some much-needed liquidity if you find yourself short of cash.
How Selling Your Accounts Receivable Works
Since selling your accounts receivable can get you cash quick, let’s take a deep dive into how it works.
Let’s say that you sell carpet. In fact, let’s call your store Carpet World. As the owner of Carpet World, you know it behooves you to eliminate any and all barriers to buying, and a big one is the cost to carpet a home. As such, you offer your customers a variety of ways to pay:
- Cash (of course!), but also
- Credit cards
As a result of your creativity and apparent generosity, you would also likely have a substantial accounts receivable list on the books, consisting of short-term notes, long-term debts, and probably some really old, musty, long-term debt (hey, I warned you!).
While, yes, technically an asset, when such debt gets too big and unmanageable, it starts to become a liability. Wouldn’t you really rather have the cash, as opposed to the debt and the hassle of having to harass people to pay up?
Enter the factor. The factor will offer to buy that entire accounts receivable from you. So now, you can answer the question once again:
Is an accounts receivable an asset?
But here’s the catch: A factor is a business, like yours is a business. And the point of a business is to make money. Well, a factor can’t make any money if they buy your $100,000 of accounts receivable for $100,000; makes sense, right?
As such, the factor will offer you what is called the “discount rate” a.k.a. the amount they will pay under the 100 percent owed to you. That’s where their profit is. A factor’s discount rate is usually between half of a percent and 5 percent.
Let’s use five percent as an example. Here, the factor would buy the $100,000 owed to you for 95 percent of its value, or $95,000. Aside from processing and other fees, that $5,000 is what the factor will earn when it collects your accounts receivable. It is money you will never see again.
The other thing to know about factoring is that you will need to contact all of your outstanding customers and let them know that they need to pay the factor now, not you, and it is the factor that will be collecting on the debt. Needless to say, that may prove to be a tad embarrassing or, if nothing else, a ding to all of that goodwill you have been accumulating.
While you may never want to sell your accounts receivable, the point is that yes, it is indeed a valuable business asset.
The Hidden Dangers of Accounts Receivable
There is no doubt that having people owe your business money is a good thing. The danger and challenge are when that debt gets too large, it can begin to interfere with your ability to run your business effectively. Here are the top concerns when it comes to accounts receivable:
Accounts Receivable are Bad for Cash Flow
If you have, say, $10,000 in outstanding accounts receivable, that is $10,000 that you don’t have available for cash flow, paying bills, buying inventory, making payroll, and so on.
The typical outstanding invoice for the typical small business is one where the customer has a period of time to pay you back, say, 30 days from when the debt was incurred. In the parlance of business accounting, this is called “Net 30.”
Now, extending credit and all may build you some goodwill, but it doesn’t pay the bills. If you have a ton of them piling up, accounts receivable won't help you. If you want to buy new equipment or hire a new employee, accounts receivable won't help. They can, in fact, hurt you if you're not paying attention to the cash you need on-hand to run or grow your business.
You Might Be Tempted to Give Customers a Long Time to Pay You Back…but Beware!
Customers, like anyone else, can experience all kinds of hardships. You might want to help them out and give them longer to pay you back. But the longer it takes a customer to pay, the less likely he or she actually will pay. Being generous with your payment terms almost ensures that you will be chasing deadbeat customers later on. Having such a bad debt expense is bad for business and bad for your cash accounts.
Back when I practiced law, we had a saying: If they can’t afford to pay you when they really need you, when they are sitting in your office scared and nervous, it is far less likely that they will pay you later, after you have helped them and they don’t need you as badly.
These once good customers become doubtful accounts, verging on bad debts.
Also, by giving customers some long-ahead, future date to pay you, you are effectively giving them three months of control over part of your finances. It throws your account balance out of whack. Those customers are the ones earning interest on that money (money that is rightfully yours), not you. They get to put that money to work for a few months, not you.
Wrong, wrong, wrong.
Good businesses—as a general rule—have short timeframes for outstanding accounts receivable. Having a lot of debt on the books for the sale of goods that occurred long ago is bad business, bad for your metrics, and a sure sign that a company’s credit sales are taking too long to be collected.
Having Accounts Receivable is Smart Business
All that being said, if you want more customers, if you want your business to grow, if you want more and bigger sales, and if you want good word-of-mouth, you’ll allow people to buy in credit and turn over your accounts receivables frequently.
Not only is that account a listing of people and businesses literally and figuratively indebted to you, but it is an incredibly useful, fungible business asset that can be sold if needed.
Accounts receivable can be one of the best things to happen to your small business.