Current Accounts Receivable
Current Accounts Receivable (CAR) are amounts due to a business from its customers within a short-term period, usually within a year. They result from offering goods or services on credit and are essential for maintaining business cash flows.
Calculating Current Accounts Receivable.
Formula:
Current Accounts Receivable = Outstanding invoices – Payments from customers within the accounting period.
Example:
Suppose a business has $50,000 in unpaid invoices for the month, and during the same month, it received $30,000 in payments from customers. The Current Accounts Receivable would be $20,000.
Importance of Current Accounts Receivable
Current Accounts Receivable (CAR) plays a pivotal role in a company’s financial structure, and its significance can be viewed from various angles:
1. Indicator of Financial Health:
At its core, a healthy CAR balance signifies that a company has a robust inflow of cash in the pipeline. When customers are buying on credit and are likely to pay within the designated period, it suggests that the business has a good volume of sales and that its products or services are in demand. Conversely, an increasing amount of bad debts or extended delays in payment might indicate potential problems, either with the company’s credit policies or with its choice of customers.
2. Cash Flow Management:
Cash flow is the lifeblood of any business. Adequate cash ensures that operations run smoothly, employees get paid, and the business can invest in growth opportunities. While CAR in itself isn’t cash, it’s a promise of cash soon to come. By monitoring and managing this balance, businesses can forecast their short-term cash inflows and make informed financial decisions.
3. Receivable Turnover Ratio & Collection Efficiency:
The receivable turnover ratio is a metric that quantifies how often, on average, a company’s receivables are collected during a period. A high ratio signifies that the company’s credit sales are frequently converted into cash, pointing to efficient collection efforts. It can also suggest that the company’s credit policies are sound and that it does a good job of extending credit only to clients who are likely to pay on time.
4. Insights into Credit Terms:
The structure and state of CAR provide insights into a company’s credit terms and their effectiveness. If a business consistently has a high CAR but struggles with actual collections, it might indicate overly lenient credit terms or inadequate follow-up procedures. On the flip side, if receivables are consistently low and collections are swift, credit terms are strict and collection processes are effective. Such insights can help businesses refine their credit policies and strategies to optimize sales and cash inflows.
In summary, Current Accounts Receivable isn’t just a ledger entry; it’s a crucial component that offers insights into a company’s operations, financial health, and customer relationships. Properly managing CAR can have cascading benefits across the entirety of a business’s operations.
Advantages and Disadvantages of Current Accounts Receivable (CAR)
Advantages:
- Improved Cash Flows: One of the primary advantages of CAR is the improvement in cash flows. When customers pay their invoices promptly, businesses have a consistent flow of cash that can be used for various operational needs, from payroll to reinvesting in the business.
- Real-time Insights into Business’s Financial Health: A well-maintained CAR gives businesses a real-time snapshot of their financial standing. When CAR is updated and accurate, business owners can gauge their company’s health and make informed financial decisions.
- Managing Credit Terms and Assessing Customer Creditworthiness: CAR plays a pivotal role in credit management. With a clear view of who owes what, businesses can set and adjust credit terms. Furthermore, by analyzing payment patterns, they can assess the creditworthiness of their customers, deciding who to extend credit to and on what terms.
Disadvantages:
- Risk of Bad Debts: One inherent risk of extending credit is that some customers might not pay. Bad debts or uncollectible accounts, represent a loss for the business. While some bad debts can be written off, they still negatively impact the company’s bottom line.
- Diligent Receivable Process and Collection Efforts Required: Maintaining an accurate and up-to-date CAR requires a well-structured and consistent receivable process. This means regular follow-ups, reminders, and sometimes even employing a collection agency, all of which demand resources.
- Possible Strain on Customer Relationships: While setting strict payment terms can ensure timely payments, it might also strain relationships with customers. For instance, if a loyal customer is going through temporary financial difficulties, too strict a stance on payment can sour the relationship.
CAR vs. CAP (Accounts Payable)
Current Accounts Receivable (CAR) is an asset, signifying amounts customers owe to a business. It arises when businesses provide goods or services on credit. The expectation is that these amounts will be collected within a stipulated credit period, thus boosting the company’s cash flows and overall financial position.
On the other hand, Accounts Payable (CAP) represents the short-term financial obligations of a company towards its suppliers or vendors. When a business procures goods or services on credit, it creates a liability, expecting to pay the supplier in the future. Unlike CAR, which boosts cash flow when collected, CAP requires cash outflow when settled.
On a balance sheet, CAR will be listed under current assets, reflecting potential income. In contrast, CAP will be categorized under current liabilities, indicating upcoming payments the company owes. The management of both these components is crucial for the financial health and liquidity position of a business.
Frequently Asked Questions:
Is the current account receivable different from the current account receivable?
Yes. While “account receivable” denotes all unpaid invoices, “current account receivable” refers only to those expected to be paid within the current accounting period.
What are current receivables and non-current receivables?
Current receivables are expected payments within a year, whereas non-current ones are anticipated beyond that period.
What type of receivables can be classified as current assets?
Receivables like unpaid invoices and credit sales expected to be cleared within a year fall under current assets.