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Accounts payable and accounts receivable both represent the flow of cash in a business. However, they have distinct differences. Account receivable refers to money that is due to your company but not yet paid. Accounts payable, on the other hand, is the money your business owes its suppliers and vendors for goods or services received but not yet paid for.Maintaining a healthy balance of cash inflows and cash outflows is essential for the financial health and stability of a business. It also allows your company to maintain positive relationships with customers and suppliers, and can improve your chances of getting a small business loan, since lenders will often look at these accounts to gauge a company’s health. Here’s a closer look at how accounts payable and accounts receivable work, their similarities and differences, plus tips on how to monitor and manage your company’s cash flow.
What Is Accounts Payable?
A company’s accounts payable are amounts it owes to suppliers and other creditors for products or services purchased and invoiced for but not yet paid for. Whenever you buy a good or service on credit (meaning you don’t pay cash up front), you have created an accounts payable. For example, if you purchase materials for $1,050 from a supplier and ask that supplier to send you an invoice rather than paying immediately, you would list that $1,050 in accounts payable. Accounts payable does not include payroll or long-term debt, but does include payments on that long-term debt. A company's total accounts payable balance at a specific point in time will appear on its balance sheet under the current (or short-term) liabilities section. Accounts payable must be settled relatively quickly to avoid default.
How Accounts Payable Works
The accounts payable (AP) department is responsible for processing expense reports and invoices, and making sure all payments are made. When the AP team receives a bill for goods or services, they need to record it as a journal entry and post it to the general ledger as an expense. Once the expense is signed off on by the appropriate person, they will then pay the bill according to the terms of the contract, such as net-30 (within 30 days) or net-60 (within 60 days), and record it as paid. A company may choose to pay its outstanding bills as close to their due dates as possible in order to improve cash flow.A strong AP team maintains good relationships with suppliers by keeping vendor information accurate, and making sure bills are paid on time. They can also help the company save money by taking full advantage of favorable payment terms and any available discounts.
Calculating Accounts Payable
All outstanding payments due to vendors, suppliers, partners, and creditors are recorded in accounts payable. As a result, if anyone looks at the balance in accounts payable, they will see the total amount the business owes all of its vendors and short-term lenders. This total amount also appears on the balance sheet.
Pros and Cons of Accounts Payable
Pros:
Keeps debts and future payments organized
Helps companies stay on track of outgoing money, as well as when they should spend vs. hold
Provides key financial information to potential investors or lenders
Cons:
Delaying payment can harm a company’s relationship with its vendors and creditors
A growing accounts payable suggests a company may be having cash flow issues or a slowdown in sales
Manual data entry can result in errors, leading to incorrect calculations, incorrect payments, and a rippling negative effects
What Is Accounts Receivable?
Accounts receivable is money that customers owe your company for products or services that have been invoiced. Some businesses request payment upon receipt of the invoice, while others give the recipient 30 or 60 days to pay.Like accounts payable, accounts receivable is recorded on a company’s balance sheet. However, it is listed under current assets (and because it’s an asset, it can be helpful for securing various kinds of business loans). Also like accounts payable, accounts receivable is for products or services that were given on credit.
How Accounts Receivable Works
Once a company delivers goods or services to the client, the accounts receivable (AR) team will invoice the customer and record the invoiced amount as an account receivable, noting the terms (such as net-30 or net-60).If the client pays as agreed, the team records the payment as a deposit. At that point, the account is no longer receivable. If the customer fails to pay on time, the AR team will likely send a late-payment letter, which may include a copy of the original invoice and list any late fees. If a customer is unable to pay its outstanding bill due to bankruptcy or other financial problems, the company may end up reporting it as an allowance for doubtful accounts on the balance sheet. This is also known as a provision for credit losses.
Calculating Accounts Receivable
In accrual basis accounting (which means revenues and expenses are recorded as they are incurred), your general ledger will show your total accounts receivable balance. Under cash basis accounting (which means revenue and expenses are recorded when money is exchanged), however, there are no accounts receivable, since a transaction doesn’t count as a sale until the money hits your bank account.Several important financial ratios rely on accounts receivable, including:
Accounts receivable turnover ratio: This measures how efficiently and quickly a company converts its account receivables into cash within a given accounting period. The formula for calculating accounts receivable turnover for a one-year period is:
Net Annual Credit Sales/Average Accounts Receivables = Accounts Receivables Turnover
Current ratio: Also known as working capital, the current ratio measures liquidity, meaning whether your company is able to pay its short-term obligations with available cash or other liquid assets. The formula is:
Current Ratio = Current Assets/Current Liabilities
Days sales outstanding: This shows how long, on average, it takes customers to pay your company for goods and services. The formula is:
Days Sales Outstanding = Accounts Receivable for a Given Period/Total Credit Sales X Number of Days in the Period
Pros and Cons of Accounts Receivable
Pros:
Extending credit can increase sales and large purchases
Helps your company acquire new customers
Makes your company more competitive with its peers
Estimating value of uncollectible receivables can be difficult
May have to work with collection agencies
Accounts Payable vs Accounts Receivable
Accounts payable and accounts receivable are two sides of the same coin, which means they have both similarities, as well as distinct differences. Here’s a closer look at how they compare.
Similarities
Both represent the flow of money within a business
Both are recorded in a company’s general ledger
An overview of both is required to gain a full picture of a company’s financial health
Both revolve around short-term financial transactions
Differences
Receivables are classified as a current asset, while payables are classified as a current liability
A payable is money to be dispersed; a receivable is money to be received
Receivables may be offset by an allowance for doubtful accounts, while payables have no such offset
Payables are recognized as income unless written off; receivables are recognized as a liability until paid
Accounts Receivable
Accounts Payable
Money to be received
Money to be disbursed
Current asset
Current liability
Result of credit sales
Result of credit purchases
May be offset by an allowance for doubtful accounts
No off-sets
Generates future cash inflow
Generates future cash outflow
How Are Accounts Payable and Receivable Related?
Both accounts receivable and accounts payable revolve around the flow of cash in and out of your business. As such, they are both often used to assess the liquidity of a company. A liquidity analysis measures whether there are enough funds coming in from receivables to pay for the outstanding payables, and if often done using the current ratio (also called the working capital ratio). As mentioned above, this is simply current assets divided by current liabilities:Current Ratio = Current Assets/Current lLabilitiesA good current ratio is typically considered to be anywhere between 1.5 and 3.
The Takeaway
Simply put, accounts payable is the money you owe, while accounts receivable is the money owed to you. Together, they represent the cash flow of a business. Understanding and tracking accounts payable and accounts receivable can help you gauge the financial strength of your business and put practices in place to generate a healthier cash flow.
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If you are launching a new business or your business is young, lenders will consider your personal credit score. Eventually, though, you’ll want to establish your business credit.
SBA loans are guaranteed by the U.S. Small Business Administration and typically offer favorable terms. They can also have more complicated applications and requirements than non-SBA business loans.
Frequently Asked Questions
What are examples of accounts payable and receivable?
Do clients pay accounts payable or receivable?
Should accounts receivable be higher than accounts payable?
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About the Author
Lauren Ward
Lauren Ward is a personal finance expert with nearly a decade of experience writing online content. Her work has appeared on websites such as MSN, Time, and Bankrate. Lauren writes on a variety of personal finance topics for SoFi, including credit and banking.
