Understanding the differences between accounts receivable and accounts payable is an essential step towards maintaining the continued health of your small business:
- Your Accounts Receivable (AR) ledger logs any money that your small business will receive from clients or customers.
- Your Accounts Payable (AP) ledger logs any money that your small business pays out to vendors or suppliers.
Let’s take a deeper look at these two concepts so you can optimize them for your small business.
What is Accounts Receivable?
You should think of Accounts Receivable as any money that your small business has earned but has not yet received. In simpler terms, you’ve delivered your service or good to your client, but have yet to receive payment in return. Ensuring that you stay on top of your cash flows, in both directions, is an essential aspect of maintaining your business’ financial health!
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 growing your business. But now comes an important question: how do you go about accepting payments from your customers, transforming your Accounts Receivable into cash inflows (aka “cash in hand”)?
This is where your payment terms enter the discussion. Let’s say that you’ve decided to give your customer 30 days to pay you back for the product or service you’ve provided them, and in this case, your payment term is 30 days. Essentially, you’ve granted a credit, or a “mini loan,” to your customer. The longer the payment term, the more credit you are extending to your the customer. It’s important to set out these terms clearly from the beginning of your relationship. Successful small business owners know that balancing customer convenience, and accepting payments is a yin and yang scenario. Invoicing software will be your best friend in this scenario!
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, while you get your paid faster. Also, be sure to weigh your options in terms of how you will accept payments, so that your choice of payment solution fits both your customers’ needs as well as your budget.
What is Accounts Payable?
Accounts Payable is the other side of this equation: it’s the money your business owes for overhead expenses like rent, phone and electric bills, insurance, or any other supplies and services you need to keep your small business running. It’s important to note that payables always represent a pending cash outflow: you’ve received something from a supplier, but have yet to pay them back for it.
So why is it important to stay on top of your Accounts Payable? Well, for one thing, it will be difficult to get a clear picture of your small business’ financial situation and plan your budget if you don’t have an efficient way to keep track of who you owe money, as well as when you’ll have to pay that money by. 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 that you pay on time is the surest way to building trust with your vendors.
What are some ways to leverage small business accounting software to ensure healthy Accounts Payable practices? Setting up automated payments is a great start. If you choose to do that, be sure to have calendar alerts set prior to payment being issued and keep a watchful eye over your small business’ bank account.
If you do find yourself in a situation where you anticipate difficulties with making a timely payments, best practice would be to reach out to the vendor and arrive at an alternate payment arrangement. In any event, small business accounting software will help you avoid annoyances like late payment fees, or high-interest debts on your small business’ credit cards.
The Balance Sheet
All of the information you record on both AR and AP will show up on your balance sheet. Accounts Receivable is recorded under assets, while Accounts Payable is recorded under liabilities. And for quick refreshers, refer to our articles on assets and liabilities, as well as how they fit into the accounting equation, here).
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:
Small business accounting can be overwhelming, but the best accounting software should always make your life easier.
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