What Are Accounts Receivable?
Accounts receivable (A/R) are money that is owed to a business by a customer or payor for services previously rendered or products sold. Any customer account that must be collected after the completed transaction is a part of a company’s accounts receivable. Actually collecting on such account may become problematic. After all, since the customer has already received the service or product, their incentive or ability to actually pay the business diminishes over time.
Accounts Receivable ‘Aging’ Report
- It is important to also understand how long the accounts receivable have been outstanding.
- Frequently, business owners with accounts receivable may create an ‘aging report‘ which categorizes the outstanding invoices by age.
- Generally, the longer the accounts receivable are outstanding, the least likely it is that they will be collected.
- Typically the aging report will categorize outstanding invoices in 30 day intervals (up to 90 or 120 days).
- Eventually, accounts receivable that are past due for more than 90-120 days are categorized as ‘bad debt’ and removed from a company’s current accounts receivable on their balance sheet.
- In a company’s balance sheet, accounts receivable are listed as a current asset.
- If any or all of the accounts receivable is converted to bad debt, then the bad debt expense is written off as an allowance for a doubtful account on the balance sheet.
Accounts Receivable Different from ‘Jobs in Progress’
Some business owners involved in the sale of their business do not understand the difference between accounts receivable and ‘jobs in progress.’ The distinction is critical because accounts receivable are typically not included in the sale (although this is always negotiable), whereas ‘jobs in progress’ are almost always included in the sale. A ‘job in progress’ refers to an outstanding job for a customer who has contracted to purchase a company’s product or service, but where the job has not been completed yet. In these instances, the company may have already incurred expenses in procuring the customer’s product or from partially servicing the job.
‘Jobs in Progress’ Almost Always Transfers in Business Sales
A ‘job in progress’ (also referred to as ‘work in progress’ in the context of business sales) is a part of a company’s goodwill or intangible assets that is almost always included in the sale and thus transferred over to a buyer of the business. As a part of the transfer of ‘jobs in progress’, the seller is usually compensated by the buyer for any costs incurred in procuring the product or partially servicing the job prior to the sales date. In contrast, accounts receivable represents jobs or transactions already performed and completed prior to the sale, and future cash flow from those jobs rightfully belong with the seller.
Danger of Too High Accounts Receivables
If a business owner has an accounts recieivable problem, then he or she may quickly have a cash-crunch that can even lead to insolvency. A business that incurs up front expenses in order to service or supply customers must receive cash in return. Otherwise they will either not be able to pay their bills, or must continually employ working capital in order to keep the business afloat. Business owners may calculate their Day Sales Outstanding (DSO) – or the time between invoicing the customer and receiving payment. By keeping track of their DSO for their customer accounts, business owners may employ different methods of ensuring that their business has a firm grasp on their accounts receivables.
Example of Business Sale with Accounts Receivable Problem
- Jack is the owner and operator of a home healthcare agency.
- The company employs skilled healthcare workers who provide patients with various healthcare services.
- After the patients are treated, the company bills the patients’ insurance carriers for their services.
- As is common in the healthcare industry, Jack is struggling to deal with his accounts receivable.
- He is not getting paid fast enough (or may never get paid) by the insurance carriers, and often has to wait more than 90 days before receiving any payment for services rendered.
- Jack wishes to sell his business, and consults with a professional business broker.
- The business broker determines that Jack’s profits on an accrual basis (which recognizes revenue as what is billed when the transaction occurs rather than collected) are $400K/year.
- However, Jack’s profits on a cash basis (which recognizes revenue as what is actually collected) is only $200K/year.
- The shortfall of profits on a cash basis is primarily the result of Jack’s ever increasing accounts receivable.
- The business broker explains to Jack that any serious buyer will explore this issue during the formal due diligence period, and that the matter must either be rectified prior to the sale or the asking price must be adjusted to account for the shortfall.
- Jack still wants to sell the business, so the business broker correctly advertises the business to have $200K/year in profits with a corresponding asking price of $500K.
- Importantly, the asking price assumes that Jack keeps his accounts receivable.
- This will allow Jack to still collect the accounts receivables after the sale occurs.
It is always best for a business owner to examine their accounts receivable situation prior to contemplating the sale of their business. Although a business seller has the option to still collect their accounts receivable after the business sale, a business must demonstrate that it does not have an accounts receivable problem in order to ensure a maximum purchase price. No buyer of a business wants to have problematic customers who do not promptly pay for products sold or services rendered.
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