Updated: Sep 21
When one thinks of how successful or unsuccessful a business is doing, it’s natural to lean towards the strategic elements of an organization that ensure profits come in: investments, funding decisions, and risk management. While these elements are important, the success of a business, especially how it runs its day to day operations, is highly dependent on the effective management of operational cash (or commonly called cash flow or cash on hand). This comes in the form of accounts payable (A/P) and accounts receivable (A/R).
Accounts Payable VS Accounts Receivable
Accounts Payable (A/P) refers to the money that the company owes to others, usually because of purchased goods or services on credit from a vendor or supplier.
Accounts Receivable (A/R) refers to the money that others owe to the company and are amounts the company has a right to collect because it sold goods or services on credit to a customer.
What’s the difference between accounts payable and accounts receivable?
In accounting, the nature of transaction dictates how it is recorded in a company’s general ledger (or financial books).
Accounts Payable (A/P) is recorded as a liability, while Accounts Receivable (A/R) is considered an asset.
Accounts Payable (A/P) will decrease the company’s cash while the opposite will happen with Accounts Receivable (A/R).
For money to go under Accounts Receivable (A/R), an invoice should be generated and delivered to the purchaser of goods or service, with payment usually expected within agreed payment terms. Accounts Payable (A/P) appears on business ledgers when an invoice is approved for payments.
Accounts Payable (A/P) = CASH OUT
Accounts Receivable (A/R) = CASH IN
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The Importance of Having a Balanced A/P and A/R
The keen management of account payables and receivables has a major impact on how liquid a business is. Liquidity in a business refers to a positive net working capital, which simply means that there is enough cash on hand to keep the business operational.
The working capital (WC) of a business is the difference between the current assets and current liabilities. The collection of assets in a timely manner and a balanced settlement of liabilities ensure a healthy and positive net working capital.
Working Capital Management
Working capital (WC) represents the operating liquidity of a business. Networking capital is the difference between current assets and current liabilities. It is important for companies to have a healthy, positive net working capital. This is achieved through, among other techniques, astute management of accounts payables and receivables.
Accounts receivables are analyzed by the average number of days to collect payment (called Days Sales Outstanding or DSO), and accounts payable are analyzed by the average number of days it takes to pay an invoice (Days Payable Outstanding or DPO).
where COGS is the cost of goods sold and COGS/day is the daily average of purchases.
DSO of less than 45 days is generally considered healthy.
Working capital can be increased by reducing the DSO or increasing the DPO i.e. collecting payment from customers quicker and delaying payment to vendors. However, there is always a business trade-off because delaying payment to vendors could tarnish the company's reputation and could also result in missing out on early payment discounts. Similarly, customers may be more willing to offer business if the company is not too strict about getting paid on time.
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