- Accounts payable (AP) and accounts receivable (AR) go hand in hand and are vital to cash flow management.
- The aim with accounts receivable and payable is for you to get paid as quickly as possible and to delay paying as long as you can.
- By tracking your accounts receivable, you ensure your customers are paying on time. That means less time and money tracking down past due accounts.
- This article is for small business owners who want to know the difference between accounts payable and receivable to better manage cash flow.
Staying on top of your accounts payable and accounts receivable is vital to the health of your business. It's true for small businesses processing a handful of transactions per day and for those handling hundreds. Accounts payable and accounts receivable go beyond tracking cash coming into and out of your business: They help you prevent unexpected expenses that could throw even the best budget off course.
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"You can have the best product or service, but if you run out of cash, you can't make more products or deliver more services," Ben Richmond, country manager at Xero, told Business News Daily. "Accounts payable and receivable are the king and queen of cash flow."
What is the difference between accounts payable and accounts receivable?
The main difference between accounts payable and accounts receivable is who owes money. Accounts payable are concerned with money you owe vendors and suppliers for business expenses. These accounts are typically recurring and treated as a current liability on your balance sheet.
Accounts receivable are the money customers owe you for your goods and services. They are recorded as a current asset on balance sheets and other accounting reports.
"The general rule is to negotiate favorable terms on accounts payable so you can pay as late as possible," Richmond said. "On accounts receivable, it's important that you get paid fast."
Did you know? Without staying on top of your accounts receivable and payable, you won't be able to manage your cash flow effectively. Nothing hurts a small business more than invoices that go unpaid or a bill you didn't prepare for.
Why are accounts payable and accounts receivable important?
Accounts payable and receivable ensure there are enough funds coming into the business to pay your bills and hopefully have cash left over. Without staying on top of payables and receivables, you can't efficiently manage your cash flow.
Managing both types of accounts allows you to budget for upcoming bills, spot ways to get better terms with vendors and suppliers, and incentivize customers to pay their bills faster. It can also cut down the time it takes to collect past-due accounts. Think cash flow management isn't important? Poor cash flow management is to blame for about 80% of business failures.
"At the end of the day, if you don't have cash, you are not in business," said Dawn Brolin, a certified public accountant and owner of Powerful Accounting. "Your AR and AP are extremely important."
What are accounts payable?
Accounts payable are a liability on the balance sheet. They are the money you owe vendors and suppliers over a certain period of time. Accounts payable are an important aspect of a company's balance sheet, not something you should overlook. They can tell you if you are relying too much on credit or overspending with vendors. If your AP increases or decreases, you'll know it by looking at your accounts payable reports.
Short-term and long-term payables
AP are typically divided into short-term and long-term payables. Short-term payables are ones you pay the vendor or supplier within a year. They are recorded as a current liability under the accounts payable header on the balance sheet. Long-term payables are debts that will take more than 12 months to pay off. They are typically recorded under the long-term liabilities header. They tend to be tied to business financing such as bond offerings.
Accounts payable cover a lot of the expenses associated with running a small business, including these costs:
- Fuel and energy
- Transportation and logistics
- Manufacturing and assembly
- Marketing and advertising
- Equipment and hardware
How do you optimize accounts payable?
Accounts payable are a standard part of running a business. By tracking them closely, you can get a better view of your vendors and suppliers. That will help you identify business partners you are over-relying on and ones you can arrange better terms with if you pay early or buy more from them.
"The general rule is to negotiate favorable terms on accounts payable," Richmond said. "You want to pay as late as possible."
Tip: To get a discount on your accounts payable, look at your vendor list and your payment history with them. If you consistently pay on time and are a reliable customer, a discount should be a no-brainer. Don't be afraid to ask vendors for discounts.
What are accounts receivable?
Accounts receivable are listed as a current asset on the balance sheet and are composed of money owed to you for your goods and/or services. They are recorded anytime a customer pays you on credit.
Keep track of accounts payable to protect your cash flow. If you aren't on top of what clients owe you and when, you won't know when a customer pays late. The longer the debt is outstanding, the more difficult it is to collect payments. Accounts receivable usually have terms of a few days to a year.
"As far as accounts receivable [go], you are concerned with shortening the window to get paid," Brolin said.
When it comes to measuring the health of your accounts receivable, most businesses use the accounts receivable turnover ratio. It tells you how well you are collecting payments from customers. Another metric to look at is the average collection period, which tells you how long it takes your clients to pay you. The longer your collection period, the worse your accounts receivable are.
Accounts receivable can include an oil company generating energy, the local dry cleaner charging corporate clients for its services, or any small business extending credit to customers. The account receivable stays on the balance sheet from the day you bill the client to the day you get paid.
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How do you optimize accounts receivable?
Managing accounts receivable requires you to stay on top of when you bill clients and when you get paid. The aim is for you to get paid as quickly as possible, which means promptly sending customers invoices, following up on unpaid bills, and offering discounts to customers who pay early. If possible, make sure your customers are paying you on a 10-day cycle, Brolin said. It's also important to keep emotions out of the mix when collecting from customers who have defaulted.
"You have to keep accounts receivable unemotional," Brolin said. "You can't get wrapped up in their dismay."
Brolin said by requiring half the payment upfront, you reduce the likelihood you'll be chasing money once the job is complete or the order is met.
Key takeaway: When collecting on past-due accounts, don't get caught up in emotions. It's OK to be sympathetic, but be firm on your payment terms and set expectations. Prevent slow or missed payments by charging 50% upfront and/or by setting up 10-day payment cycles.
What are discounts on accounts receivable and accounts payable?
To optimize cash flow, you want to get paid as quickly as possible and take as long as you can to pay vendors. That is where accounts payable and accounts receivable discounts come in.
Accounts receivable discounts
A common way to get customers to pay early is to offer an early-payment discount. This means charging the customer a reduced price if they pay before the due date. Consider your current profit margin to determine how much of a discount to offer. Make it worthwhile for the customer, but don't eat away at your profit too much.
These are some examples of payment discounts:
- 2/10, Net 30: Customers get a 2% discount on a bill that's due in 30 days if they pay within 10.
- 3/15, Net 45: Customers get a 3% discount on a bill that's due in 45 days if they pay within 15.
- 5/10, Net 60: Customers get a 4% discount on a bill that's due in 60 days if they pay within 10.
Accounts payable discounts
The goal is always to pay vendors as late as possible and on the best terms. Depending on your relationship with the supplier and your track record paying, you can get a vendor discount if you pay early or upfront. This is the same as an accounts receivable discount, but instead of collecting money, you are paying it out. Discounts may also be available if you buy in bulk or on a consistent basis.
"A discount is a discount," Brolin said. "If you get a 1% discount on a $10,000 bill, that's $100. You can utilize it for something else."
Tip: Don't shrug off a discount, even if it's small. If you can afford to pay early without negatively impacting your cash flow, and you save some money, that's a win-win.