Two concepts important to any business owner or business analyst are accounts receivable and accounts payable. These like-sounding accounts on the financial statements have very different meanings and understanding both is essential to any business owner.
Definition of Accounts Payable
Accounts payable are obligations of a business to re-pay a certain amount to another party. If a business receives inventory but has 30 days to pay for it until that bill is paid the business has an account payable for the amount due. Similarly, if a utility bill comes and isn’t paid for a few weeks, that balance is an account payable to the business.
Accounts payable are almost always a current liability (in that they have to be paid within a year) with longer debts being considered a long-term debt or some other form of obligation. The importance of managing accounts payable is that it represents a relatively short-term cash outflow that the business will have to pay. When looking at a business’s ability to cover its short-term obligations accounts payable and other short-term payables will be compared to the short-term assets of the business. If the short-term assets exceed short-term liabilities that are generally considered to be a healthy financial indicator.
Definition of Accounts Receivable
Accounts receivable represent amounts due to a business from a third party. Similar to accounts payable these are usually short-term amounts due and represent what the company expects to receive in the next year. In some circumstances and industries, the normal terms of payment may be more than a year resulting in long-term accounts receivable also being on the financial statements.
When many businesses make sales there is not an immediate cash inflow, even if paying by credit card it may take a few days to actually have the cash in the business account. In some cases, customers can have several weeks or months to pay, and during that time the cash you expect to receive is considered to be an account receivable.
One unique factor for accounts receivable is that businesses are often required to make an estimate of what percentage of amounts due to them will not actually be recovered. This bad debt expense is often based on past experiences and for some businesses can be as high as 1-5% of sales that they make. By expending this amount it is removed from accounts receivable and no longer reflected as cash the company expects to receive.
Accounts Payable vs. Accounts Receivable
When looking at accounts payable and accounts receivable it is important to keep in mind that these accounts both reflect expected cash inflows and outflows of a company. How a company manages these balances is important, as it reflects the efficiency of management. A significantly increasing accounts receivable indicates that the business is struggling to actually get paid for work performed (which is definitely not a good thing) and that some amount may not be recoverable and is in fact a bad debt. A steadily increasing accounts payable is not necessarily a good thing either, as while it represents less cash going out there is still going to be a need to pay these amounts out. Companies with cash flow problems often see it first in increasing accounts payable where they are struggling to make payments to suppliers.