A recent Intuit QuickBooks survey found that nearly 70% of small business owners are kept up at night worrying about cash flow. Cash flow — the movement of money into and out of your business — indicates whether your business is thriving or just barely surviving.
Accounts payable (AP) and accounts receivable (AR) are two important cash flow indicators. Understanding what these terms mean, their differences, and how to track and manage AP and AR are two critical business skills for small business owners. Here’s what you need to know about these metrics.
[Read more: Accounting Basics Every New Business Owner Should Learn]
Accounts payable vs. accounts receivable
Accounts payable refers to all outstanding bills you owe for products and services your business purchased, excluding payroll costs. These expenses are not immediately paid and are considered “liabilities” in your accounting books. For example, imagine your finance manager needs a new laptop, and you buy one on the company credit card. Until that charge is paid off, the purchase will be recorded in your accounts payable.
[Read more: A Quick Guide to Accounts Payable]
Accounts receivable refers to payments that your customers or vendors owe you. If you have provided a good or service that hasn’t yet been paid for, that item is recorded as a current asset. Imagine you run a landscaping company and regularly charge for your lawn mowing services after you’ve completed the job. Until your customer pays the bill, the outstanding amount is recorded under accounts receivable.
Bottom line: AP refers to charges owed by your business to suppliers/services. AR refers to charges that customers/suppliers owe your business.
By clearly seeing how much you owe at any given time, you can make better decisions around spending, pricing, and negotiating with suppliers.
Differences between accounts receivable and accounts payable
Accounts payable helps ensure that your business doesn’t fall behind on any payments that are due. It also makes your liabilities (e.g., debts) more transparent, and therefore easier to accurately project your cash flow. By clearly seeing how much you owe at any given time, you can make better decisions around spending, pricing, and negotiating with suppliers.
Accounts payable should record the following information:
- The biller’s name and account number, if applicable.
- The invoice number.
- The type of expense (e.g., overhead, inventory, one-time, recurring, etc.).
- The date the invoice was received.
- The payment deadline.
- The status of the payment.
Accounts payable is also an important function in the case of an audit. As a result, you should keep records of purchase orders, invoices, contracts, and agreements with your vendors and contractors as part of your accounts payable function.
Accounts receivable is the other side of the equation. Tracking how much money is owed to your business ensures that you’re earning a healthy amount and covering your costs. Usually, accounts receivable has a two-month repayment window. Generally speaking, there are three types of accounts receivable:
- Notes receivable: This account type uses a promissory note to promise payment will be made within one year, rather than the typical two months. The promissory adds a legal component to your outstanding debt, helping ensure you receive payment.
- Trades receivable: This account type refers to a business asset. “The difference between a Trades Receivable Account and accounts and notes receivable is that it is a direct result of company sales. When a customer buys a good or service and is extended short-term credit in which to repay the loan, this is listed as a trades receivable entry in the current trades receivable account,” wrote Freshbooks.
- Bad debt: If the customer or buyer can’t make the payment, you may have to write their account off as bad debt. This means you lose out on the income; however, there are tax credits that can help offset this loss.
Both AP and AR are worth understanding in order to get a handle on your healthy cash flow. Without clear information from these accounts, it will be difficult to see whether your business is operating at a profit or loss. As a result, employ someone, outsource to a third-party, or work carefully on your own to make sure all your records are up-to-date and carefully managed.
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