Differences Between Accounts Receivable and Accounts Payable Explained

Every business either waits for payments (accounts receivable) or owes payments (accounts payable). These are the business's two aspects that complement each other and drive the business forward. When revenues and expenses are in a healthy balance, the business may take advantage of growth prospects and maintain great relationships with suppliers and consumers.

Since one is an asset account and the other is a liability account, it is critical to distinguish between the two on a company's balance sheet. Mixing them up can lead to a lack of balance, insufficient operating capital, or worse, bad debt.

This guide will explore the major difference between accounts receivable and accounts payable, the processes and challenges involved, their significance in financial management, how to manage them effectively, and more.

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What is Accounts Receivable?

The term accounts receivable, or AR, describes unpaid invoices that clients owe your business for goods or services that were billed. It indicates a line of credit that has been given from the company to the customer.

The total value of all accounts receivable is shown on the balance sheet as current assets since the payment terms for these accounts vary from a few days to a full year. 

Example: Interest receivable, which you receive from investments or from holding funds in an interest-bearing account. Until you get that payment, the sum is noted as accounts receivable in your business's financial records.

Accounts receivable are a key component of several significant ratios, such as:

The accounts receivable turnover ratio, sometimes referred to as the "debtors turnover" or "receivable turnover" ratio, gauges how effectively and swiftly a business turns its accounts receivable into cash throughout an accounting period.

Formula:

Accounts receivables turnover = Net annual credit sales / average accounts receivables

The current ratio, also known as working capital, is a measure of liquidity that indicates whether your business can meet short-term obligations with cash on hand or with other liquid assets that can be turned into cash within a year.

Formula:

Current ratio = current assets / current liabilities

Days sales outstanding (DSO) indicates the typical time it takes for customers to pay your business for goods and services provided.

Formula:

DSO = accounts receivable for a given period / total credit sales x number of days in the period

The Accounts Receivable Process

The flow of the AR procedure is quite simple. When searching for a payment, an AR team has to follow three basic steps to ensure timely collection of payments and accurate tracking of what’s owed. They are:

The above flowchart illustrates the steps of the Accounts Receivable process in sequential order, with each step connected and dependent on the other.

1. Invoice Issuance: Once the goods or services are delivered to the customer, the business issues an invoice, mentioning the amount due and the payment instructions. 
2. Tracking and Follow-up: Invoices are routinely tracked using a trial balance. If payment is not received within the agreed timeframe, the business sends reminders or initiates further action (such as phone calls or collections) if necessary.
3. Payment Receipt: After receiving the payment, the last step is to confirm that the amount is accurate and mark it as "paid" in the ledger.

So, what’s accounts payable? Let’s find out next.

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What is Accounts Payable?

On your business's general ledger, accounts payable, or AP, is an account that signifies the obligation to settle a debt owed to suppliers or creditors. In other words, it is the money that your company owes third parties for goods or services that you have bought and invoiced for. 

It is regarded as a current liability account since it usually contains short-term debts that the company anticipates paying off in a year or one operational cycle, whichever comes first.

Example: If your business obtains raw materials from a supplier and receives an invoice with terms such as "Net 30," it must pay the provider within 30 days. Until that payment is made, the sum is noted as accounts payable in your business's financial records.

Days payable outstanding (DPO) is a crucial metric that finance teams should monitor. This illustrates how long it typically takes your business to pay suppliers and debtors, as well as how effectively you are handling cash flow and supplier relations.

Formula:

DPO = average accounts payable / cost of goods sold x number of days in the accounting period

Where average accounts payable = accounts payable balance at the beginning of period - ending accounts payable balance / 2

The Accounts Payable Process

The AP process has five key steps, starting with invoice receipt and ending with payment release.

The above flowchart illustrates the steps of the Accounts Payable process in sequential order, ensuring a structured and efficient payment process.

1. Invoice Receipt: A business gets an invoice asking for payment after buying products or services from a vendor.
2. Record: The next stage is entering the invoice into the accounts payable ledger. This procedure can be automated if you have accounting software. 
3. Invoice Verification: The invoice is compared to the purchase order and delivery receipt to ensure that the quantities and terms are correct.
4. Approval: Following verification, the invoice is sent to the appropriate divisions (such as finance or procurement) for permission prior to payment. At this point, it passes through a series of controls to ensure the payment is justified and recognized as an obligation.
5. Payment: The last stage is to ensure that the invoice is paid on schedule, in the correct amount, and accordance with the terms of payment. The accounts payable staff ensures this. The entry should be deleted from the account after payment has been made. 

Also Read: Understanding Debits and Credits in Accounting

Having a brief overview of accounts payables and receivables, you must be wondering about their differences. Let’s jump into that now.

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What is the Difference Between Accounts Receivable and Accounts Payable?

In this section, we’ll examine the main difference between AR and AP in more detail, emphasizing their effects on your business operations and financial health.

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After learning the fundamentals of accounts payable and receivable and the distinction between the two, it is crucial to understand the real significance of these accounting procedures.

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Importance of Accounts Payable and Accounts Receivable in Business Finance

AP and AR are vital because both are fundamental to a company’s financial health. They immediately affect cash flow and, when tracked effectively, enable strong fiscal decision-making. Companies that offer these opportunities may be able to save money via payment discounts or enhance customer loyalty.

Why is Accounts Receivable Important?

• It enables businesses to track and record sales prior to receiving payment, which facilitates financial decision-making and reporting and gives a more comprehensive view of the business's economic performance.
• It enhances liquidity evaluations, as it is a crucial component of current assets and immediately affects a company’s working capital position.
• By assisting in the prediction of future cash inflows, it optimizes cash flow management, which is crucial for efficient budgeting and financial planning.
• It helps in prompt invoicing and payment follow-up to minimize revenue disruptions.
• It facilitates credit control by evaluating consumer creditworthiness, decreasing the chance of bad debt.

Why is Accounts Payable Important?

• It helps to manage short-term cash flow by determining which payments to postpone or make first to take advantage of discounts.
• By helping to make payments on schedule, it helps build trust with suppliers, often leading to better payment terms, discounts, and consistent supply quality.
• It helps monitor and control business spending, providing information about spending trends and potential opportunities for cost reduction.

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Common Challenges in Managing AR and AP

Managing financial issues can be difficult at times, especially when it comes to important procedures like AP and AR. The majority of firms face the following typical difficulties while handling AP and AR functions:

Accounts Receivable Challenges

The total amount in unpaid invoices across all U.S. small businesses is approximately $825 billion, equivalent to about 5 percent of the U.S. GDP. This highlights the need to study the challenges involved in managing AR. 

• Unsatisfactory customer service with late payers.
• Insufficient time to oversee the collection procedure.
• Establishing credit limits and carrying out recurring credit evaluations.
• Collections from clients who have filed for bankruptcy or are about to do so.
• Manual tracking and payment reconciliation lead to missing payments and mismatched invoices.
• Lacking the necessary capabilities to handle AR data and accounts.

Accounts Payable Challenges

• Manual three-way matching of invoices with purchase orders and delivered products, which is laborious and error-prone.
• Significant losses result from email-based fraud and theft, as well as check fraud.
• Exception and missing invoices that show the cash balance and dues incorrectly.
• Unauthorized purchases without proper purchase orders.
• Duplicate payments as a result of using several payment methods or the supplier's failure to acknowledge them.

Does your business face the above challenges while managing accounts receivables and account payables? Let South East Client Services (SECS) take control of your unpaid invoices and ensure timely payments of your dues to optimize your financial position. 

Technology and automation can be utilized to streamline both the AR and AP processes. Let’s find out how.

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Role of Technology and Automation In Streamlining Accounts Receivable and Accounts Payable

Automation in accounts receivable (AR) is revolutionizing how businesses manage their collections. Let’s find out how. 

• The latest AR automation software simplifies critical tasks, allowing businesses to monitor receivables status, track customer interactions, and schedule payment reminders—all while reducing the risk of bad debt. 
• With tools like automated emails and alerts, you can stay connected with customers, ensuring timely payments and faster cash cycles. 
• The integration of real-time reporting and analytics provides a complete view of cash flow, enabling businesses to identify potential issues and address them quickly.
• The shift to automated invoice-processing platforms that incorporate computerized data capture and optical character recognition (OCR) technology further reduces errors and enhances invoicing efficiency. 

Accounts payable (AP) automation is transforming how companies manage their payments, with technologies like Robotic Process Automation (RPA) and AI making the process faster and more accurate. 

• AP software can automate almost all steps in the workflow, leaving approvals to be handled with just a few clicks. Hence, there are fewer human errors, accurate data processing, and timely payments to suppliers, avoiding late fees. 
• With automated workflows, issues in the AP process can be identified and resolved quickly, while analytics tools provide valuable insights into payment trends and cash flow. 
• The ability to implement automated payment plans and self-service portals also simplifies payments for vendors and customers, making the process smoother and more efficient. 
• Integrating AI and machine learning for sophisticated debt collection strategies enhances overall payment management and supports better decision-making.

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Conclusion

Understanding the difference between accounts receivable (AR) and accounts payable (AP) is crucial for maintaining a positive cash flow, ensuring smooth operations, and managing a business's financial health. While AR focuses on the money owed to a business by customers, AP revolves around the money a business owes to suppliers. 

South East Client Services (SECS) specializes in managing and servicing delinquent account receivables and assists in tracking and managing your payables. Our team of experts provides knowledgeable support in optimizing these accounting processes, ensuring accurate and compliant financial reporting. 

Contact SECS today to make accounts receivables management a breeze for your business.

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