What is Accounts Receivable (AR)?
Accounts Receivable (AR) represents the credit sales of a business, which have not yet fully been paid by its customers. Companies allow their clients to pay at a reasonable, extended period of time, provided that the terms are agreed upon. For certain transactions, a customer may receive a discount for paying the receivable back to the company early.
The average AR days assumption is an important part of forecasting changes in non-cash working capital in financial modeling.
Why do companies have Accounts Receivable?
Some businesses allow selling on credit to make the payment process easier. Take, for example, a phone provider. This provider may find it hard to collect payment perpetually every time someone makes a call. Instead, the provider will bill periodically at the end of the month for the total amount of service used by the customer. Until this monthly invoice has been paid, the amount will be recorded in account receivable.
Allowing purchase on credit also encourages more sales. Customers tend to hold on to cash but are more inclined to purchase on credit if possible.
Risks of outstanding Accounts Receivable balances
There are several risks associated with carrying a large AR balance, including:
- Uncollected debt – high A/R that goes uncollected for a long time is written off as bad debt. This situation occurs when customers who purchase on credit go bankrupt or otherwise do not pay the invoice.
- Cash flow deficiencies – a business needs cash flow for its operations. Selling on credit may boost revenue and income, but it offers no actual cash inflow. In the short-term this is acceptable, but in the long run can cause the company to run short on cash and have to take on other liabilities to fund operations.
AR’s impact on cash flow and financial modeling
When a company has an accounts receivable balance it means that a portion of revenue has not been received as cash payment yet. If payment takes a long time, it can have a meaningful impact on cash flow. For this reason, in financial modeling and valuation, it’s very important to adjust free cash flow for changes in working capital, which includes AR, accounts payable, and inventory.
In the example below, you can see how AR is portrayed on the balance sheet in one of CFI’s financial models.
Source: CFI financial modeling course.
Watch the video tutorial below to learn more about accounts receivable and accounts payable:
Thank you for reading this guide to Accounts Receivable (AR) and how it impacts a company’s cash flow. To keep learning and advancing your career as a financial analyst, check out these additional resources: