Accounts Receivable and Accounts Payable Demystified
By: Hugh Pendleton, President
We've all heard of accounts receivable (A/R) and accounts payable (A/P), but what do they mean? Simply put, accounts receivable tracks the amount of money due to your business from clients, and accounts payable tracks the money you owe to your suppliers and vendors.
The question I get asked most often is why A/R and A/P matter in running a business. Can't you just monitor your bank balances? To answer that, let's consider how you manage your personal finances. You never calculate how much money you have only by your bank balance. You take into account your monthly bills, when your paychecks will come in, and whether you have any extra expenses or deposits hitting your account. If the only insight you had into your personal finances were that day's balance, you'd run the risk of overdrafts and missed payments, not to mention the difficulty you'd face planning for future big-ticket items like vacations or college tuition.
Efficient A/R and A/P systems track and distinguish actual revenue and expense versus amounts received and paid. Without A/P, paid and unpaid bills aren't recorded in your financial statements, and without A/R, paid and unpaid customer invoices aren't recorded or tracked. This knowledge is essential for understanding your business's cash flow and for supporting your short-term and long-term business goals.
These systems will help you map out your cash flow and profit margins so you can appropriately time investments in things like new equipment or expansion. They'll also help you understand how your revenue is affected by seasonality (more customers in summer vs. winter, for example) and you can use this information to better target your sales and marketing efforts.
The efficiency of both systems relies on timeliness. How many clients do you or your bookkeeper chase down for payments every month, or perhaps every few months? Without an A/R system, holding delinquent clients accountable for payment is a nightmare. They might push off settling their accounts, argue about unsatisfactory work, or claim you overcharged. And the more time that goes by, the less likely you are ever to receive payment.
With a seamless A/R system, you or your bookkeeper can send monthly statements, and almost everyone will pay immediately upon getting one that shows them past due. An official, documented payment reminder is often more effective than a phone call or email that can be ignored or rationalized away.
As for accounts payable, make sure to pay your suppliers on time, every time—don't wait for them to remind you. The better customer you are, the more likely they are to help you quickly if a problem occurs or you need a short extension.
A/P systems record expenses as they happen rather than when you pay them to give you a real-time picture of your business. If you run your business on a cash basis (i.e., via your bank balance), you won't ever really know how well you're performing or what your actual profits are.
An A/P system also helps you avoid double-paying bills and matches income with those bills and other expenses. Matching is essential because your bookkeeping system doesn't know about your unpaid bills unless you record them. If you don't record or pay them, your bank account might look good and you might feel good, but it's a false sense of prosperity that could mask growing problems. With a reliable A/P system, you'll have real insight into the health of your business along with the ability to identify and fix problems early.
I know plenty of business owners who believe bookkeeping costs too much. I don't think so. I think lost A/R costs too much. I think missed opportunities cost too much. I think upset suppliers cost too much. I think penalties cost too much. Don't let your fear of bookkeeping stop you from investing in the tools and systems your business needs to thrive.
If you need help setting up or managing your A/R and A/P, come talk to us. We can keep your books stress-free and on track.