What is Accounts Receivable?
Accounts Receivable (A/R) is defined as payments owed to a company by its customers for products and/or services already delivered to them – i.e. an “IOU” from customers who paid on credit.
Accounts Receivable (A/R): Accounting Definition
Under accrual accounting, the accounts receivable line item, often abbreviated as “A/R”, refers to payments not yet received by customers that paid using credit rather than cash.
Conceptually, accounts receivable represents a company’s total outstanding (unpaid) customer invoices.
Given the fact that the customer has not yet paid the company, the question becomes: “Is accounts receivable an asset or a liability?”
Since the unmet payment obligation represents a future economic benefit to the company, the accounts receivables line item is categorized as a current asset on the balance sheet, i.e. the company anticipates to receive the owed payment in cash soon.
However, as part of the revenue recognition policy established under accrual accounting standards, the amount charged to the customer is recognized as revenue once the customer is billed, irrespective of the fact that the cash still remains under the possession of the customer.
Whether cash payment was received or not, revenue is still recognized on the income statement and the amount to be paid by the customer can be found on the accounts receivable line item.
Accounts Receivable Formula
For purposes of forecasting accounts receivable in a financial model, the standard modeling convention is to tie A/R to revenue, since the relationship between the two are closely linked.
More specifically, the days sales outstanding (DSO) metric is used in the majority of financial models to project A/R. DSO measures the number of days on average it takes for a company to collect cash from customers that paid on credit.
The formula for days sales outstanding (DSO) is calculated as follows.
To properly forecast A/R, it’s recommended to follow historical patterns and how DSO has trended in the past couple of years, or to just take an average if there appear to be no significant shifts.
Then, the projected accounts receivable balance can be determined using the following formula.
- Increasing DSO → If the days sales outstanding (DSO) of a company have been increasing over time, that implies the company’s collection efforts require improvement, as more A/R means more cash is tied up in operations.
- Decreasing DSO → But if DSO declines, that implies the company’s collection efforts are improving, which has a positive impact on the cash flows of the company.
How to Interpret Change in Accounts Receivable (Increase or Decrease)
If a company’s accounts receivable balance increases, more revenue must have been earned with payment in the form of credit, so more cash payments must be collected in the future.
On the other hand, if a company’s A/R balance declines, the invoices billed to customers that paid on credit were completed and the money was received in cash.
To reiterate, the relationship between accounts receivable and free cash flow (FCF) is as follows:
- Increase in A/R → The company’s sales are increasingly paid with credit as the form of payment instead of cash.
- Decrease in A/R → The company has successfully retrieved cash payments for credit purchases.
With that said, an increase in accounts receivable represents a reduction in cash on the cash flow statement, whereas a decrease reflects an increase in cash.
On the cash flow statement (CFS), the starting line item is net income, which is then adjusted for non-cash add-backs and changes in working capital in the cash from operations (CFO) section.
Since an increase in A/R signifies that more customers paid on credit during the given period, it is shown as a cash outflow (i.e. “use” of cash) – which causes a company’s ending cash balance and free cash flow (FCF) to decline.
While the revenue has technically been earned under accrual accounting, the customers have delayed paying in cash, so the amount sits as accounts receivables on the balance sheet.
Accounts Receivable vs. Accounts Payable: What is the Difference?
- Accounts Receivable (AR): Current asset recorded on the balance sheet that captures the outstanding cash payments still owed from customers, i.e. the money owed from customers that paid using credit.
- Accounts Payable (AP): Current liability recognized on the balance sheet that reflects the cash payments that the company owes to suppliers and vendors, i.e. the company paid using credit as the form of payment.