Accounts receivable

Accounts receivable is an asset on the balance sheet representing the amount that customers owe the company for goods or services already delivered or performed. It exists because companies use accrual-accounting: revenue is recognized when delivered, not when cash is received. Until a customer pays, the unpaid amount is carried as accounts receivable. Managing accounts receivable is critical: it represents cash tied up in the business, and some amounts will never be collected. The allowance-for-doubtful-accounts is the offsetting reserve.

How accounts receivable arises

When a company sells goods or services on credit (a common arrangement in business-to-business sales), it recognizes revenue immediately under accrual-accounting. The customer owes the company money, which is recorded as accounts receivable.

Example: An electrical contractor completes a project for a commercial customer on November 30 and invoices $50,000. The contractor recognizes $50,000 of revenue in November (the income statement reflects the profit). The customer’s payment of $50,000 in January is received as cash, and accounts receivable decreases. The income statement is unaffected by the timing of cash collection.

Accounts receivable on the balance sheet

Accounts receivable appears on the balance sheet as a current asset (assuming payment is expected within one year). It is listed net of the allowance-for-doubtful-accounts, which is a reserve for amounts expected not to be collected.

For example:

• Gross accounts receivable: $100 million
• Less: allowance for doubtful accounts: ($5 million)
• Net accounts receivable: $95 million

The net amount is what appears on the balance sheet. The allowance is estimated based on historical collection rates and current economic conditions.

Aging of receivables

Investors often look at the aging of accounts receivable — how old the unpaid invoices are. This is disclosed in footnotes and gives insight into collection effectiveness and credit quality.

A typical aging might be:

• Current (0–30 days): $60 million
• 30–60 days past due: $25 million
• 60–90 days past due: $10 million
• Over 90 days: $5 million

If recent aging shows a shift toward older receivables, it may signal that customers are paying slower or the company is extending more generous credit terms.

Days sales outstanding (DSO)

A common metric for accounts receivable efficiency is days sales outstanding (DSO), calculated as:

DSO = (Average accounts receivable ÷ Revenue) × 365 days

A DSO of 45 days means the company collects its receivables, on average, in 45 days. DSO varies by industry: a retailer with mostly cash or credit card sales might have DSO of 10 days; a manufacturer selling to distributors might have DSO of 60 days.

Increasing DSO can signal rising collection risk or looser credit terms. Decreasing DSO might signal tightening credit or improved operations.

Working capital tied up in receivables

Accounts receivable represents working capital — cash tied up in the business that could otherwise be used. A growing company often sees accounts receivable rise faster than revenue, consuming cash.

This is why the cash flow statement adjusts operating cash flow for changes in accounts receivable. When receivables grow, it reduces cash flow from operations (the company is not yet collecting the revenue). When receivables shrink, it increases cash flow (the company is collecting cash from prior-year sales).

Credit quality and the allowance

The company must estimate what percentage of accounts receivable will not be collected. This estimate becomes the allowance-for-doubtful-accounts, a reserve. The difference between the estimate and actual uncollectible amounts is the bad-debt-expense on the income statement.

A company with strong credit management and low default rates will have a smaller allowance (e.g., 2% of receivables). A company with weaker customers or lenient credit policies might have a larger allowance (e.g., 5% or more).

See also