Accounts Payable vs. Accounts Receivable

Managing cash flows is one of the most important—and challenging—aspects of running any business. Accounts payable (AP), which is a short-term liability, and accounts receivable (AR), which is a short-term asset, are two important aspects of financial management that directly affect a business’ cash flow, financial liquidity, and ability to continue operating.

Late payments, missed invoices, and poor cash flow management can lead to financial instability, strained supplier relationships, and potentially bad debts or legal issues. In this article, we’ll explain the difference between accounts receivable and accounts payable, why these figures are important, and how to manage them effectively.

Key Takeaways

• Accounts payable, also known as AP, is the money your business owes to suppliers for goods or services purchased on credit.
• Accounts receivable, also known as AR, is the opposite of AP—it’s the money your business is owed for goods and services it provided to a client that was paid on credit.
• Managing AP and AR efficiently can help ensure timely payments, receive funds promptly, and cultivate positive relationships with suppliers and clients.
• Accounting software can streamline and automate receivable and payable processes, saving businesses time and money.

What Is Accounts Payable?

Accounts payable, aka AP or A/P, represents the money a business owes to suppliers for goods and/or services it purchased on credit but has not yet paid for. AP is generally required to be paid in full within 30, 60, or 90 days of receiving an invoice from a supplier or vendor.

Because of its relatively short-term due dates, accounts payable is recorded in the current liabilities section of a company’s balance sheet. Current liabilities are debts that are due in one year or less. In contrast, long-term liabilities are debts that are due in more than one year.

Accounts payable is an important element of sound financial management. Managing AP effectively can help ensure timely payments to suppliers, improve supplier relationships and avoid penalties or potential legal trouble with vendors. Conversely, poor AP management can lead to cash flow issues and damage to a business’ reputation and creditworthiness.

How to manage accounts payable

There are several strategies companies can use to manage their accounts payable more effectively. However, potentially the most important factor is cultivating positive relationships with suppliers. Let’s explain the best ways for business owners to manage accounts payable effectively:

• Keep track of invoices and payment due dates to stay on top of payments.
• Negotiate favourable payment terms with suppliers to optimise cash flows and align with your business’ workflow. Favourable payment terms can include payment discounts, which encourage businesses to pay invoices earlier and reward them for doing so.
• Use accounting software to document, record, and track transactions with vendors, store invoices, automate payments, and set helpful AP reminders.
• Cultivate positive relationships with suppliers and vendors. This can not only benefit your accounts payable management, but it also helps keep suppliers on your side as your business grows and your supplier requirements evolve.

Accounts payable example

Let’s say your business purchased £1,000 in office supplies from XYZ Office Supplies on credit. The vendor delivered the supplies and sent you an invoice requesting full payment within 30 days. To incentivise you to pay early, they offer a 5% discount for payment in 15 days or less. You use this option and pay £950 within 15 days of receiving the invoice.

In accounting terms, this example would be handled as follows: The initial receipt of goods and the £1,000 invoice would increase both the office supplies asset account and the AP current liability account by £1,000 each. After the invoice has been paid, the AP liability account will decrease by £1,000, the cash account will decrease by £950, and the purchase discounts income account will increase by £50.

What Is Accounts Receivable?

Accounts receivable, aka AR or A/R, is essentially the other side of AP. AR is the money that is owed to a business by its clients or customers for goods or services that have been purchased on credit and delivered but have not yet been paid for.

Invoices generally must be paid within 30, 60, or 90 days, depending on the supplier’s requirements and any contracts. As a result, accounts receivable is listed as a current asset on the balance sheet. Current assets are those with useful lives (the amount of time you can use the asset before it breaks or stops working) of one year or less, while long-term assets are those with useful lives of more than one year.

Managing AR effectively is an important part of optimising cash flow. Accelerating the collection of cash improves your business’ ability to invest, fund operations, and take advantage of new opportunities when they arrive. Similarly, delayed payments or past-due receivables that are determined to be uncollectible can significantly strain a business’ finances.

How to manage accounts receivable

Managing accounts receivable involves a few different simple strategies efficiently over time. Below, we explore the best ways for businesses to manage accounts receivable effectively:

• Issue invoices promptly and include clear payment terms, such as amounts, descriptions of goods or services provided, discounts offered, accepted payment methods, etc.
• Follow up on any overdue payments with customers as quickly as possible.
• Consider conducting credit checks on new customers to whom you’re offering credit. This can help minimise your risk and work with clients who are capable of paying bills on time.
• Consider offering incentives like payment discounts, which typically range from 1% to 3%, to encourage customers to pay invoices early.
• Most importantly, do your best to maintain a positive relationship with your customers. This alone can incentivise clients to pay bills on time, and it may also encourage them to continue working with you as their business continues to grow and their needs expand.

Accounts receivable example

Let’s use the same example as we did above, but instead of purchasing the office supplies, you’re selling the supplies as XYZ Office Supplies. You receive an order for £1,000 worth of office supplies from ABC Co. on credit.

You ship the supplies to ABC Co. and send them an invoice for £1,000 with payment terms of 30 days with a 5% deduction if the invoice is paid within 15 days. ABC Co. pays the invoice within 15 days, so you receive £950 in cash.

To account for this transaction, you would debit the AR asset account for £1,000 to increase it and credit Revenue for £1,000 to increase it. When ABC Co. pays the invoice, you will credit the AR account for £1,000 to decrease it, debit the Cash account for £950 to increase it, and debit the Sales Discounts account by £50 to account for the 5% discount.

How AR and AP Impact Cash Flow

Cash flow is an important financial aspect of every business. Cash is the lifeblood of a company, affecting investment opportunities, liquidity, the ability to pay bills, and the sentiments of investors and lenders. It also reduces the need to procure loans and pay interest. AR and AP both impact cash flow in the following ways:

• AP’s cash flow impact: Paying suppliers, while necessary, is a cash outflow. This reduces cash flow in the short term. Delaying payments to suppliers with agreed-upon payment terms can preserve cash on hand for longer, giving you more control over it.
• AR’s cash flow impact: Collecting payments from customers is a cash inflow, which improves your cash flow. Accelerating payments from customers as much as possible allows you to collect cash earlier and increase your cash on hand. This gives you a greater ability to pay bills and take advantage of investment opportunities.

How To Manage AR and AP Efficiently

Let’s explore several strategies you can implement to improve the management of your receivables and payables. These strategies can improve cash collection, resulting in healthy cash flow, liquidity, and customer/supplier relationships.

Use accounting software to automate processes

Using capable accounting software is one of the quickest and easiest ways to begin optimising your AP and AR processes, allowing you to automate many of their elements.

Accounts payable automations let you:

• Pay suppliers by the appropriate due dates
• Track invoices
• Track accounts payable accounting entries
• Create accounts payable aging reports

Accounts receivable automations let you:

• Create invoices
• Send invoices
• Send payment reminders to customers
• Track accounts receivable accounting entries
• Create accounts receivable aging reports

While accounting software does come at a cost, it will allow you to save time, decrease administrative expenses, and reduce errors when it comes to managing payables and receivables.

Use accounts receivable and accounts payable aging reports

Regularly review AP and AR aging reports, which are financial reports that denote when each AP or AR amount was created and how long they’ve remained on the balance sheet. These reports can be found in your accounting software, and they can give you an idea of which receivables and payables to follow up on first. They also indicate which receivables may be uncollectible or significantly past their due dates.

AP and AR aging reports are important for ensuring that receivable amounts of older accounts don’t become past due or uncollectible. ‘Uncollectible’ refers to an AR amount that is likely never to be paid, which means your business would miss out on that income. Keeping track of AR aging reports can help prevent this possibility.

Negotiate favourable payment terms

Work with suppliers and vendors to negotiate payment terms that work with your business. This can help align payments with your cash flow cycle, ensuring that you always have the cash on hand to pay invoices on time. This could include setting favourable payment deadlines or negotiating discounts for early payments. Similarly, work with customers to set up invoice terms that allow them to pay you on time.

Improve invoicing practices

It’s important to issue invoices promptly and consistently after delivering goods or services to clients. This gives them time to plan the payment and ensure that their other operations can continue running smoothly, improving their financial health and keeping them happy.

You should also ensure that your invoices include transparent payment terms, deadlines, discounts, and payment methods to give customers a clear understanding of how, when, and how much to pay.

Additionally, consider using electronic invoices to reduce the potential for lost emails, delays in opening the post, or customers forgetting they received an invoice. Electronic invoices allow customers to easily save, store, and revisit invoices at any time. This also establishes a line of communication that will enable you to send payment reminders in the future.

Set credit policies for accounts receivable

For AR, it’s important to ensure clients have a history of making payments on time and in full. The best way to do this is to conduct a credit check on all new customers. Furthermore, consider setting credit limits based on customers’ financial history, income level, and level of collateral.

Connect with an accounting professional

An accounting professional can help remove confusion around your accounts receivable and accounts payable processes. They can streamline accounting tasks, optimise your current AP and AR practices, improve your cash flow, and ensure that your business has a plan for limiting tax implications, saving you money, time, and stress.