Have you ever wondered why it’s so important for business owners to know the difference between accounts payable and accounts receivable? It all comes down to cash flow (or lack thereof), which is one of the most common culprits that cause businesses to close shop. In fact, a study by JPMorgan Chase, found that the average small business makes just $7 more cash per day than it spends and has only 27 days of cash on hand at any given time.
The good news is that managing accounts receivable and payable can help small businesses get a bigger picture of their financial health and improve cash flow. Riley Adams, a CPA, former senior financial analyst at Google, and founder of The Young and the Invested, agrees. “In my experience, though accrual-based accounting can give you a sense of how your business is performing overall, ultimately you need to see a steady cash flow to pay the bills,” he says. “One of the most important aspects of understanding the differences between accounts payable and accounts receivable is that it’s a balancing act, and you always want more cash coming in than going out.” Furthermore, understanding the differences between the two can make businesses much more resistant to bankruptcy.
So, in this small business guide, we’ll explain what accounts payable and receivable are, how they differ, and some cash flow basics to keep in mind.
“One of the most important aspects of understanding the differences between accounts payable and accounts receivable is that it’s a balancing act, and you always want more cash coming in than going out.”
— Riley Adams, CPA, former senior financial analyst at Google, founder of The Young and the Invested,
What are accounts receivable (AR)?
First things first, accounts receivable (AR) simply refers to the money owed to your business by customers. For example, a customer paying $1,000 down for a $5,000 sale would result in $4,000 of accounts receivable (and the balance the client owes you to complete the transaction).
One important exception to this rule exists. If a customer makes a formal, long-term agreement to pay (with interest), the money owed is considered notes receivable, not accounts receivable.
How to record accounts receivable
In a nutshell, accounts receivable are current (also known as short-term) assets on your business’s balance sheet. To record accounts receivable, you’ll need to take a couple of steps: Credit revenue and debit accounts receivable.
To visualize this, the journal entry below records the prior example (ignoring inventory/cost of goods sold) and appears as:
|April 10, 2023||Cash||$1000|
|May 10, 2023||Accounts receivable||$4000|
What are accounts payable (AP)?
In many ways, accounts payable (AP) is the opposite of accounts receivable. That’s because any money your business owes to vendors is generally considered accounts payable. For example, making a down payment of $2,000 for $10,000 of branded laptop bags would result in accounts payable of $8,000 (which is the money you still owe to the company supplying the merchandise).
It’s important to remember that accounts payable only include transactions with vendors and don’t usually involve other parties like lenders or employees. Also, similar to the accounts receivable exception mentioned earlier in this article, written long-term payment arrangements with interest are considered notes payable rather than accounts payable.
How to record accounts payable
Accounts payable represent the current (sometimes called “short-term”) liabilities that appear on the balance sheet of your business. Recording accounts payable requires a debit to the related asset or expense and a credit to accounts payable. The prior laptop bag example requires the following journal entry:
|February 10, 2023||Branded Laptop bags||$10,000|
|February 15, 2023||Cash||$2,000|
Similarities and differences between accounts receivable and accounts payable
Next, let’s look more closely at what these two concepts have in common (as well as a couple of differences).
What similarities do accounts payable and receivable share?
Accounts receivable and accounts payable share several surprising similarities. First, almost all businesses have obligations related to accounts receivable and accounts payable in some shape or form. So, what are some other key concepts they share? Here are some:
- They are considered short-term accounts, with payment expected within a year — and usually much less time.
- AP and AR provide businesses with opportunities to improve their cash flow.
- Both involve the core operations of a business — that’s because revenue tends to generate accounts receivable, while the purchase of inventory usually creates accounts payable.
One more thing these accounting principles have in common is that most business owners recognize how important they are to their organization’s success. That said, there can be times when managing accounts receivable and payable to increase cash flow presents challenges. Adams explains that it has to do with the steps that happen once a transaction is complete.
“One thing that may not occur to small businesses is that there’s much more that has to happen after making the sale, “ he says. “You need to have processes in place to get that cash in-house after you reach an agreement with a client.”
Now that we have an idea of what these two important concepts have in common, let’s take a little time to see where they differ.
What is the difference between accounts receivable and accounts payable?
The fundamental difference between accounts receivable and accounts payable is that accounts receivable represent assets (money owed to your business) while accounts payable represent liabilities (money owed by your business).
As discussed below, accounts receivable and accounts payable require very different management.
Managing accounts receivable in your business
Savvy business owners always try to minimize accounts receivable, opting to receive cash instead. Even though accounts receivable are assets, they can’t directly pay your business’s bills like cash. As the saying goes: cash is king. As companies close many deals quickly, it can sometimes be overlooked.
“It’s easy to think that all transactions immediately add up to cash flow,” explains Adams. “But since most businesses accept credit — there’s a little bit (or sometimes larger) gap between making the sale and getting the cash in hand.” Therefore, you want to do everything possible to encourage your customers to pay immediately and in full, which is an important consideration for small business owners to wrap their heads around.
In addition, Adams points out, “Most small business owners need to understand that having positive cash flow is a perpetual game of trying to get clients to pay their invoices (ahead of what you need to pay vendors or service providers to keep your business serving customers).”
Though there are many ways to go about it, generally, this involves:
- Having a system in place for prompt invoicing
- Clear sales terms which state when payments are due
- Frequent follow-ups using communications such as email, phone or text
- Occasional discounts in exchange for prompt payment
“Most small business owners need to understand that having positive cash flow is a perpetual game of trying to get clients to pay their invoices (ahead of what you need to pay vendors or service providers to keep your business serving customers).”
— Riley Adams, CPA
What if my customers fail to pay accounts receivable they owe?
There is always the risk that your customers will fail to pay, which sometimes comes with the territory in the world of small business. Turning over extremely late invoices to a collection agency sometimes makes sense, although they tend to charge significant fees and can create tension with customers. There’s always a chance a client goes bankrupt altogether — in which case you’ll likely receive little or none of the money owed. Even if your customer stays in business, collecting unpaid bills is sometimes costly and becomes increasingly difficult the longer they remain unpaid.
In fact, most businesses track accounts receivable based on how long they’ve held them. In some cases, you may have to write off the receivables as uncollectable, incurring unwanted bad debt expense. On the plus side, tracking your bad debt expense also allows you to calculate the likely future cost of bad debt and adjust prices accordingly.
Managing accounts payable in your business
Most well-run companies try to approach accounts payable in the exact opposite way, delaying payment as much as possible in order to conserve cash. However, there’s one important exception to this rule: discounts for prompt payment.
Some business owners seeking long-term savings are willing to pay more upfront in exchange for a lower total cost of goods and services. And there are plenty of vendors who are happy to oblige by offering discounts in exchange for prompt payment.
Consider the following invoice terms: 2% 10 net 30. These are payment terms that have an incentive built in for prompt payment:
- The “2% 10” means you’ll get a 2% discount off your total balance if the invoice is paid within 10 days (or you pay the full balance if between days 11 – 30).
- Otherwise, the invoice comes due in 30 days, as indicated by “net 30.”
Taking advantage of this type of discount, however, does not always make sense, and when to do so varies from business to business. If cash starts to run tight, you might need to conserve it to make sure you’re able to pay those critical bills that keep the infrastructure of your organization up and running.
One more thing to note is that while not all vendors offer prompt payment discounts (or advertise this), you can always ask if they’ll consider extending one to your business. Once more we spoke with Riley Adams for his take. “To quote Wayne Gretzky, you miss 100% of the shots you don’t take,” says Adams. “As a small business, it is always worth asking for terms that can improve your bottom line.”
What if I can’t pay my accounts payable?
Unfortunately, simply writing off accounts payable like uncollectable accounts receivable is typically not an option. That’s because your business still owes the money — whether you can pay it or not. In extreme cases, you may have to prioritize which bills to pay. However, this can lead to additional charges, financial problems, interruption of key supplies and services, and legal ramifications. Failure to pay can also make it very difficult to work with a key vendor in the future.
If you are absolutely unable to fulfill the commitments you’ve agreed to, your best bet is to contact suppliers proactively and be transparent about the situation (and see if you can figure out a path forward). The reality is that most vendors will work with you rather than risk not collecting at all.
We’ve covered a lot of ground but before we wrap up, let’s close with some insights on making decision points related to cash flow.
Cash flow decision points
As we discussed earlier, most business owners understand how important cash flow is, but may not be as familiar with what Adams calls “cash flow decisions” or “decision points” to help strategize ways to get cash in the door as soon as possible. Here are some he says are worth a closer look:
Lease vs Buy
- When considering a purchase, is it something you really need to own (which is the larger cash outlay), whereas leasing is usually a smaller cost out-of-the-gate.
Contractor vs Employee
- Contractors may be more flexible – the expectation (for both you and the contractor) is they’ll complete a project and move on once it’s done. On the other hand, employees cost more but come with more control on how to use their time. Consider the pros and cons (and of course) the costs.
Outsource vs Insource
- In the long run, it may just be less expensive to outsource tasks you need completed instead of trying to handle them in-house (for example, working with an outside tax professional and getting the peace of mind that comes with it). This could free up time and resources to bring in a new hire who handles things such as customer service – which might be cost more upfront, but ends up making you more money down the road (and positively impacting your cash flow).
Offer Discounts for Cash Payment vs Credit
- Another option is to offer to see if a client is willing to pay cash instead of credit – direct deposit payment, cash, ACH (which may take a business day or two) in exchange for a discount. In most cases, there’s no waiting — since you are getting paid immediately.
- It can also be a way to encourage customers to refrain from using a credit card. And on the other hand (as mentioned earlier) as a company, you may offer to pay cash in exchange for a discount.
Managing accounts receivable and payable is the foundation for your business’s cash flow and long-term success. Minimizing accounts receivable and maximizing accounts payable can significantly improve your cash situation. On the flip side, strategically paying accounts payable early may also lead to valuable discounts. The main takeaway is that with some planning (and a firm grasp of the fundamentals) many companies experience positive cash flow in the long run.