What are Receivables?
Receivables, also referred to as accounts receivable, are debts owed to a company by its customers for goods or services that have been delivered or used but not yet paid for.
- Companies that allow customers to purchase goods or services on credit will have receivables on their balance sheet.
- Receivables are recorded at the time of a sale when a good or service has been delivered but not yet been paid for.
- Receivables will decrease when payment from customers is received.
- The amount of receivables estimated to be uncollectible is recorded in an allowance for doubtful accounts.
Receivables are created by extending a line of credit to customers and are reported as current assets on a company's balance sheet. They are considered a liquid asset, because they can be used as collateral to secure a loan to help meet short-term obligations. Receivables are part of a company’s working capital. Effectively managing receivables involves immediately following up with any customers who have not paid and potentially discussing a payment plan arrangement, if needed. This is important because it provides extra capital to support operations and lowers the company’s net debt.
To improve cash flow, a company can reduce credit terms for its accounts receivable or take longer to pay its accounts payable. This shortens the company's cash conversion cycle, or how long it takes to turn cash investments such as inventory into cash for operations. It can also sell receivables at a discount to a factoring company, which then takes over responsibility for collecting money owed and takes on the risk of default. This type of arrangement is referred to as accounts receivable financing.
To measure how effectively a company extends credit and collects debt on that credit, fundamental analysts look at various ratios. The receivables turnover ratio is the net value of credit sales during a given period divided by the average accounts receivable during the same period. Average accounts receivable can be calculated by adding the value of accounts receivable at the beginning of the desired period to their value at the end of the period and dividing the sum by two. Another measure of a company’s ability to collect receivables is days sales outstanding (DSO), the average number of days that it takes to collect payment after a sale has been made.
If a company sells widgets and 30% are sold on credit, it means 30% of the company's sales are in receivables. That is, the cash has not been received but is still recorded on the books as revenue. Instead of a debit to increase to cash at the time of sale, the company debits accounts receivable and credits a sales revenue account. A receivable does not become cash until it is paid. If the customer pays the bill in six months, the receivable is turned into cash and the same amount received is deducted from receivables. The entry at that time would be a debit to cash and a credit to accounts receivable.
Allowance for Doubtful Accounts
Under U.S. generally accepted accounting principles (GAAP), expenses must be recognized in the same accounting period that the related revenue is earned, rather than when payment is made. Therefore, companies must estimate a dollar amount for uncollectible accounts using the allowance method.
This estimate for bad debt losses is recorded as both a bad debt expense on the income statement and displayed in a contra account below accounts receivable on the balance sheet, often called the allowance for doubtful accounts. The net of accounts receivable and the allowance for doubtful account displays the reduced value of accounts receivable that is expected to be collectible. Businesses retain the right to collect funds even if they are in the allowance account. This allowance can accumulate across accounting periods and will be adjusted periodically based on the balance in the account and receivables outstanding that are expected to be uncollectible.