This series will take you behind some of the metrics you should be measuring in your business, including: profit, accounts payable and receivable, inventory and payroll. We’ll talk about what they are, what they really mean and more.
It’s important to understand the ins and outs of your accounts payable and accounts receivable. To begin, let’s look at what they actually are:
Accounts payable: Money owed by you to your vendors.
Accounts receivable: Money owed to you by your customers.
Accounts payable and accounts receivable are different sides of the same coin. When you talk about accounts payable, you’re discussing the money you owe. On the other side, accounts receivable measures how much money others owe you.
When you buy goods or services from someone and don’t pay them for it at the time of transaction, you’re buying them on credit. This is tracked in your accounting system as an account payable. This seems like it should go without saying, but you need to pay these off within a given time to avoid incurring late fees and/or interest. Some vendors are even nice enough to offer discounts if you pay early.
Accounts payable are current liabilities, meaning they are due within a year. However, we all know vendors typically don’t give you a year (most are due on receipt or within 30 days). There are other liabilities like short-term loans, payroll costs or income taxes for your business, but those are recorded elsewhere.
Think of accounts receivable as your outstanding invoices. It’s like you’ve received an IOU from your customers. They have a legal obligation to pay you back.
Similar to accounts payable, the accounts receivable is a current asset—we’re talking, at the most, due within a year. But again, you likely aren’t going to give your customers a year to pay you back. If a company cannot collect on its accounts receivable, they do have options for recourse, including taking the debtor to court or handing over the debt collection to a third-party bill collector.
As a fun fact, if a company has bad debt (accounts receivable was recorded as income but payment was not received), the IRS allows you to subtract it from your gross income on your income tax return. However, this is only as long as the debt was reported as income on a previous return. But if by chance your customer comes through (after you record it as bad debt), you will need to record a bad debt recovery (income) when the money is received.
AP and AR are key accounting metrics to understand. We recently talked about other basics of accounting you’ll need to know.
Tracking Your Accounts
To track your accounts payable, your number guru credits accounts payable when a bill is owed and debits accounts payable when the bill is paid. Of course, we’re just talking here about the accounts payable section of your accounting system. In reality, the full tracking looks like this:
- When an invoice is received, the invoice is recorded as a credit to accounts payable and a debit to another account(s) within your system like inventory or expense (this is called double entry accounting).
- When an invoice is paid, the payment is recorded as a debit to accounts payable and a credit to cash (or in some cases credit card payable).
To track your accounts receivable, your number guru debits accounts receivable when an invoice is created and credits accounts receivable when payment for the invoice is received. Of course, we’re just talking here about the accounts receivable section of your accounting system. In reality, the full tracking looks like this:
- When an invoice is created, the invoice is recorded as a debitto accounts receivable and a credit to another account(s) within your system like income.
- When payment for the invoice is received, the payment is recorded as a credit to accounts receivable and a debit to cash.
In its simplest form, the accounts payable turnover ratio is a measurement of the rate you’re paying off your short-term debt to suppliers. It’s calculated like this:
Total Supplier Purchases
Average Accounts Payable
This matters because this calculation allows your investors (and you) to see how often you pay your average payable amount to your vendors. When your turnover ratio falls, it means you’re taking longer than normal to pay off your short-term debts. When the turnover ratio rises, you’re paying off vendors at a faster rate.
Your accounts receivable turnover ratio is your ability to effectively extend credit and collect debts on those credits. In other words, how well you are collecting on the debts your customers owe you.
It’s calculated like this:
Net Credit Sales
Average Accounts Receivable
A high receivable turnover ratio often means your collection policies are effective and efficient. You have a good quantity of customers who pay off debts owed to you in a timely fashion. Or, it could mean you’re conservative with the amount of credit you extend. A low ratio can tell you that you have a poor collection process or are being too generous with your extensions of credit. It could also mean you have customers who aren’t willing to pay off their debt or are having difficulty doing so.
Big differences in turnover numbers can tell you a story about your cash flow but these aren’t the only components of cash flow. For example, if your accounts receivable turnover is low compared to your account payable turnover, it means you are paying your suppliers faster than your customers are paying you. This could create decreased cash flow and you might be feeling the pressure. However, if your accounts receivable turnover is high compared to your accounts payable turnover, you might be seeing a cash influx. But it’s important to remember you have accounts payables coming due, so don’t be quick to spend it all.
Accounts receivable and accounts payable (and their respective turnover ratios) tell a part of your company’s story. By examining them and continually measuring them, you can see ways to adjust course, change methods or improve systems in order to help make you a more successful business.
Understanding the basics of accounting will help you succeed in the long run.