Accounts Payable and Accounts Receivable

Posted by PITHOCRATES - November 26th, 2012

Economics 101

Someone’s Account Payable is Someone’s Account Receivable

Cash is king in small business.  Because without it you can’t make payroll or pay your payroll taxes.  As important as cash is, though, many business will never grow until they start offering credit.  Trade credit.  Selling things on account.  Because for those doing repeat business it is just too much of a pain to write a check for every purchase.  And it’s just dangerous carrying around that kind of cash.  So businesses offer credit to established customers.  Those with good credit.  And good reputations.

Customers open an account.  When they make a purchase they get an invoice generally payable in 30 days.  Or some number of days around that.  At the end of the month they will receive a statement from their vendor showing all of their open invoices.  Which they will compare with their accounting records.  By running their accounts payable report.  And they will compare the invoices they show outstanding with those on their vendor’s statement.   They will resolve any differences.  And then write a check for their outstanding invoices.

On the other end of the sale there is an account receivable.  For someone’s account payable is someone’s account receivable.  A sale that doesn’t bring cash into the business.  But a promise to pay cash within a short amount of time.  So a business can greatly increase sales by offering trade credit.  By being a mini-banker.  Their sales revenue will grow.  As will their net profit.  But not necessarily their cash in the bank.  For it will look good on paper.  But until they convert those accounts receivable into cash it will only be on paper.  And money on paper is just not as good as money in the bank.

When Invoices are Unpaid for 90 Days or More there’s a Good Chance they will Never be Paid

There is a certain euphoria small business owners feel when they see their sales grow.  Things are moving in the right direction.  All their hard work is paying off.  Finally.  Some even fantasize about spending some of that money.  Such as going out to lunch on Friday instead of brown-bagging it every day of the week.  Then some anxiety starts growing.  And it comes from their accounts receivables report.  When they see that 30 days after those sales come and go.  And a lot of those open invoices remain on the report.

The accounts receivable report small business owners review is called an aging report.  Because it shows what invoices are current, which are 30 days old, which are 60 days old and which are 90 days or more old.  And when invoices are unpaid for 90 days or more there’s a good chance they will never be paid.  In fact, once they pass 30 days the chances that their customers won’t pay them grow greater.  And this is the source of a small business owner’s anxiety.  When he or she sees those invoices move from 30 days to 60 days to 90 days.

Why do some customers pay slower than others?  Because they, too, have accounts receivable moving from 30 days to 60 days to 90 days.  And if they’re not collecting their money in a timely manner then can’t pay their bills in a timely manner.  When the economy slows down you will see a lot of businesses start to pay their bills slower.  And as they pay their bills slower businesses collect their money slower.  Which forces them to pay their bills slower.  Or, worse, borrow money to pay their bills until their customers pay theirs.

To encourage their Customers to Pay their Bills Timely many Businesses will offer Early Payment Discounts

Sales are great.  Everything that’s good follows from sales.  Sales are the first step in creating cash.  And cash is king.  But between cash and sales are accounts receivable.  Which can make or break any small business.  For you can’t often grow sales without extending credit.  But if you extend too much credit and/or your customers don’t pay their bills a business owner can lose everything he or she worked for.  Because when it comes down to it, sales are great but cash is king.

To encourage their customers to pay their bills timely many businesses will offer early payment discounts.  If the customer pays their invoice within 10 days, say, they will get a 2% discount on that invoice.  So if they have a $1000 invoice they only have to pay $980.  As an owner will trade $20 in profits to speed up their cash collections.  And if you look at some numbers you can see why.  If they have $150,000 in new sales in one month that 2% discount will cost them $3,000 in profits.  Now compare that to the cost of borrowing cash from an 11% credit line to replace the cash they can’t collect from their customers.  If they have receivables of $150,000 at 30 days, $300,000 at 60 days and $49,950 at 90+ days the interest cost to borrow money to replace these funds can add up to $3,322.46.

So an early payment discount can equal a business’ borrowing costs.  Making it a wash.  While offering a huge benefit.  Allowing a business to pay their bills.  Like payroll.  Payroll taxes.  And their vendors.  For in difficult economic times all businesses have cash problems.  And will do almost anything to improve their cash position.  And when it comes to paying their bills and they can’t pay them all guess which ones they’re going to pay first?  Those that help their cash position.  That is, those invoices that offer an early payment discount.  Because sales are great.  But cash is king.

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