Accounts receivables form one of the important components of current assets of a business. These are the second most important type of current assets after inventories for a business. Further, accounts receivables also constitute the third most important asset for a business after plant and equipment and inventories.
In India, businesses make a good amount of investment in accounts receivables. Thus, it is important that companies manage their accounts receivables efficiently to provide for savings. This management of receivables is commonly referred to as management of trade credit.
What is Trade Credit?
Trade credit is nothing but selling goods on credit to customers. Credit sales are usually done to lure customers to purchase products or services at attractive terms and conditions. Furthermore, these sales are made to deter customers from purchasing the underlying goods or services from the other competitors.
However, selling goods on credit to customers creates accounts receivables that further leads to blocking of business’ funds. This means that business has to make use of its working capital to provide finance for the period between credit sales and payment collection for such sales.
Thus, business needs to carefully manage its accounts receivables as considerable amount is tied up in such accounts. So let’s understand what are accounts receivables and why is it important to manage them efficiently.
What Are Accounts Receivables?
Accounts receivable is defined as the amount owed by the customer to the firm on account of sale of goods or services during the ordinary course of business. Such customers are known as the debtors of the company. This is because they owe money for the goods purchased by them on credit.
A business sells goods on credit to its customer when it does not receive the payment for the same immediately. In other words, the business provides trade credit to its customers. This means the customers get reasonable time to pay for the goods and services purchased by them. Further, this credit is what leads to creation of bills receivable or book debts or debtors in your balance sheet.
Characteristics of Accounts Receivable
Accounts receivables have certain key characteristics that are as follows:
- The accounts receivables have an element of risk and thus should be carefully managed. This is because cash against such credit sales is yet to be received from the customers.
- Secondly, the accounts receivables have an economic value attached both for the buyer as well as the seller. The buyer derives economic value out of the goods and services immediately at the time of sale. However, the seller attains such a value when he receives cash payment for such sales at a later date.
- Lastly, a business must analyze and manage accounts receivables properly. This is because the cash payment for such sales is collected from the customers in future period.
Furthermore, managing accounts receivables calls for a cost. These costs include both direct and indirect costs. Direct Costs constitute:
- cost of investment
- discounts and allowances given to customers and
- losses arising out of bad debts.
Indirect Costs on the other hand include costs associated with :
- Collection of receivables
- Recording of bills
- Preparing financial statements
- Sending collection reminders
- Inflationary costs
- Legal expenses
Why is it Important To Maintain Accounts Receivable?
The ultimate aim of providing credit to customers is to augment sales. Customers get time to pay for the goods purchased on credit. Thus, this gives them the advantage of making the best use of their resources. Further, customers need not borrow money to finance their working capital needs. Likewise, there are different ways in which extending trade credit is useful both for the business as well as it customers. Thus, the main objectives of maintaining accounts receivables are as follows:
1. Increase in Sales
Businesses typically prefer selling goods or rendering services in cash. In other words, a large part of their company sales include cash sales. Such sales generates prompt payment from the customers on selling goods or services to them. However, selling on cash basis may not always be possible for the business. This is because there can be customers who are not willing to make prompt payment for the goods or services received.
Thus, business needs to think of some favorable terms and conditions it can offer to such customers. This is because such customers would otherwise prefer buying goods and services from competitors on attractive credit terms.
Therefore, it is important for a business to sell goods or services on favorable credit terms in order to retain and attract such customers. Thus, we can say credit sales create receivables that help in boosting overall sales of the business.
2. Maintain Liquidity
Accounts receivables are one of the current assets that can be easily converted into cash. Not only that, it is also one of the major current assets of a business including inventories. Since current assets can be converted into cash within 12 months, accounts receivables help in maintaining liquidity.
Ideally, every asset on the balance sheet can be converted into cash. But when we compare bills receivables with inventory, bills receivables are more liquid. This is because accounts receivables represent the amounts that customers owe for goods or services already purchased by them. And therefore, as a business, you can easily convert bills receivable into cash as compared to an item in your inventory.
Thus, maintaining a sound accounts receivable management policy helps in getting cash speedily. Further, the business can use such cash towards meeting its short-term obligations such as paying for current liabilities or investing in growth opportunities.
Accounts Receivable Process
It is recommended that a business must formulate a proper accounts receivable process. This is in order to know the amount received and due from the customers for the goods and services sold to them. The process includes the sequence of events that help in tracking and managing bills receivable.
1. Putting a Credit Practice At Place
The first step in formulating accounts receivable process is arriving at a credit application process. Such a process is put in place to determine whether the applicant customer has the desired credit worthiness for purchasing goods on credit. The business may choose to sell goods on credit either to individuals or to other business units.
Further, a business must also put into place the terms and conditions for selling goods on credit. Such terms and conditions basically specify the requirements and commitments on the part of its customers. These include credit period, discount and penalty in case the payments are received beyond the credit period agreed.
So, the credit terms and conditions vary depending upon the size of business. Larger businesses extend credit to customers for longer periods given their financial soundness. However, smaller businesses sell goods on a shorter credit period due to less capital availability and lower cash flows.
2. Generating Invoices
Invoice is basically an instrument that contains details of:
- Goods or services sold
- Price of goods or services
- Quantity of goods
- Date of payment
- Unique invoice number
- Purchase order
Usually, customers are given a choice to receive invoices in electronic form or in physical form. Businesses must send invoices to its customers without delay. This is because the longer a business takes to send invoices to customers, the longer customers take to make payment against them.
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3. Keeping Track Of Payments Received and Payments Yet To Be Received
Once the invoice is generated, the next step is to keep track of payments received or payments due from customers. This is usually done by the accountant. Further, the details with regards to the payment method and the date of receipt of payment are required to be recorded in the customer’s ledger account.
Such a practice ensures that the credit amount standing against the customer is recorded correctly. Lastly, businesses are required to send reminders to customers who are yet to make payments against their respective invoices.
4. Keeping Accounts For Bills Receivable
The designated accountant must keep a proper record of the dates on which such bills become due. This is done to ensure that payments against bills receivable are received on time from the customers.
On receiving payments against such bills receivable, the accounts of the concerned customers must be settled.
To understand how the journal entries for accounts receivables go into books of accounts, let’s consider an example.
Kapoor Pvt Ltd sold goods on credit to Singhania and Sons worth Rs 2 Lakhs on April 1,2 018. Now, since the goods are sold on credit, Kapoor Pvt Ltd would not receive cash against such sales immediately. So, the amount to be received from Singhania and Sons would be an asset for Kapoor Pvt Ltd. This is because the payment for such goods would be received on a future date. Hence, this is recorded in books of accounts as bills receivable, book debts or debtors.
Needless to say, there will be an increase in accounts receivable as well as revenue for Kapoor Pvt Ltd. The journal entry as on that date is as follows:
Accounts Receivable A/c Dr. 2,00,000
To Sales A/c Cr 2,00,000
Now, on June 1, 2018, Kapoor Pvt Ltd received cash worth Rs 2 Lakh from Singhania and Sons. So, the cash account of Kapoor Pvt Ltd would increase by the same amount. This is on account of receipt of cash for credit sales worth Rs 2 Lakhs from Singhania and Sons. However, the bills receivable of Rs 2 Lakhs would be written off in the books of Kapoor Pvt Ltd. This is because Singhania and Sons has now made the payment for goods received. Following is the journal entry for the transaction:
Cash A/c Dr. 2,00,000
To Accounts Receivable A/c Cr. 2,00,000