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 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
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. Collection of assets in a timely manner and a balanced settlement of liabilities ensure a healthy and positive net working capital.
Management of Working Capital (WC)
To effectively manage one’s working capital, the Days Sales Outstanding (DSO) of accounts receivables should be less than 45 days. DSO refers to the average number of days accounts receivable payments are collected. Accounts payable are analyzed by the average number of days it takes to pay an invoice (Days Payable Outstanding or DPO).
How do you increase working capital?
Reducing DSO and increasing DPO can increase working capital. Simply put, businesses collect payments from customers faster and delay vendor payments. However, increasing working capital isn’t as easy as it looks as delaying vendor payments can tarnish a business’ reputation and faster payments collection can turn off customers, as they usually prefer businesses that aren’t too strict about getting paid on time.
Ideally, you should always have more accounts receivables (income) than payables (operational business expenses). This is where having a positive net working capital means business profit.
For effective management of operational cash, some businesses hire companies that offer accounting outsourcing services. This way you can focus on the core business decisions while your outsourcing partner takes care of accounting operations so you won’t need to worry about anything.
Managing your business’ finance and accounting on your own is taxing and does not always result in favorable results. With our customized solutions, rest assured that all your concerns would be addressed accordingly and at the same time, it would allow you to concentrate on other important factors vital for your company’s growth. Learn more!