Even if you're new to accounting, you can probably guess the basic idea behind Accounts Receivable vs Accounts Payable based on their names. Accounts Receivable is money "to be received" by your business from a client or customer. Accounts Payable is money "to be paid" by your company for a product or service provided by a vendor. Pretty simple so far, right? Those are the basics, but now let's get into some of the nuances of these two types of accounts and what they mean in terms of how you run and grow your business.
What is Accounts Receivable?
First, let's take a look at Accounts Receivable: money you have earned, but which has not yet been received (aka, it's not "cash in hand" yet). Think of it as somewhere in between cash outflow and inflow, in the sense that you have already provided a service or delivered a product to the client (cash outflow), but have not yet received your payment (cash inflow).
Read more about cash flow: "What is Cash Flow and Why is it so Important?"
Dealing with Accounts Receivable is great, because it means you're making sales and therefore growing your business. Now comes an important question: how do you go about collecting payments from your customers, transforming your Accounts Receivable into cash inflow (aka "cash in hand")? This is where payment terms come in. Let's say you've decided to give your customer 30 days to pay you back for the product or service you've provided them: in this case, the payment term is 30 days. Essentially, you've granted a credit, or a "mini loan," to your customer from the date the product or service is provided until the date they pay you back for it. The longer the payment term (typically anywhere from 30 to 90 days), the more credit you are extending to the customer. It's important to set out these terms clearly from the beginning in a way that balances customer convenience and making sure that you get paid on time. This is usually done in a contract.
You might want to think about giving your clients an incentive to make their payments early, such as a discount, reduced interest, or free shipping. This way, everybody wins: your customer is rewarded for making an early payment, and you get your inflow of cash sooner, which is great for your bottom line and increases the likelihood of gaining a repeat customer. Also be sure to weigh your options in terms of which payment method you'll go with, whether it be electronic transfer, Square, or PayPal, so that you find the solution that fits your customers' needs and your budget. And remember, some of these payment methods have fees associated that either you or the customer pays.
What is Accounts Payable?
If Accounts Receivable is all about "money in the door," Accounts Payable is the other side of that coin: it's the money your business owes for overhead expenses like rent, phone and electric bills, insurance, and the other supplies and services you need to keep your business running. And just like Accounts Receivable represents a pending inflow of cash, you can think of Accounts Payable as a pending cash outflow: for now, you still have the cash in hand, but you owe a debt to the vendor/supplier at the end of the set payment term.
So why is it important to stay on top of your Accounts Payable? Well, for one thing, it's pretty hard to get a clear picture of your business' financial situation and plan your budget if you don't have an efficient way to keep track of who you owe money, how much, and when. And while the rare late payment here and there may not be too much cause for concern, if late payments or partial payments become a habit, this can seriously damage your reputation with the vendors you deal with. Making sure you pay on time (or even before the due date) allows you to build trust with vendors, and they may be more lenient if you do need to work out an alternate payment arrangement further down the line.
What are some ways to build healthy Accounts Payable practices? Setting up automated payments is a great start. If you do that, make sure you have calendar alerts set for a few days before the payment due date so that you can check to make sure there's sufficient cash in the account from which the payment will be drawn. If you do find yourself in a situation where you anticipate difficulties with making a timely payment, it would be a good idea to reach out to the vendor as early as possible to make them aware of the situation and come to an alternate payment arrangement. Avoiding getting slammed with late payment fees just makes sense for your bottom line, as does making a point of paying off higher-interest debts in months with higher cash flow.
The balance sheet
How does all this information on Accounts Receivable and Accounts Payable show up on your balance sheet? Accounts Receivable is recorded under the category of assets, while Accounts Payable would be recorded under liabilities (read more about assets and liabilities and how they fit into the accounting equation).
Now that we've had an overview of Accounts Receivable and Accounts Payable, why not check out these two articles for a more in-depth look at each type of account:
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