According to research by Relay Financial Technologies, 88% of small businesses in the United States face regular cash flow disruptions. Cash flow—the movement of money into and out of your business—indicates whether your business is thriving or just barely surviving. And for many small business owners, it’s one of the most stressful parts of running a business.
Accounts payable (AP) and accounts receivable (AR) are two important cash flow indicators. Understanding what these terms mean, their differences, and how to track and manage AP and AR are two critical business skills for small business owners. Here’s what you need to know about these metrics.
[Read more: Accounting Basics Every New Business Owner Should Learn]
Accounts payable vs. accounts receivable
Accounts payable refers to all outstanding bills you owe for products and services your business purchased, excluding payroll costs. These expenses are not immediately paid and are considered “liabilities” in your accounting books. For example, imagine your finance manager needs a new laptop, and you buy one on the company credit card. Until that charge is paid off, the purchase will be recorded in your accounts payable.
[Read more: A Quick Guide to Accounts Payable]
Accounts receivable refers to payments that your customers or vendors owe you. If you have provided a good or service that hasn’t yet been paid for, that item is recorded as a current asset. Imagine you run a landscaping company and regularly charge for your lawn mowing services after you’ve completed the job. Until your customer pays the bill, the outstanding amount is recorded under accounts receivable.
Bottom line: AP refers to charges owed by your business to suppliers/services. AR refers to charges that customers/suppliers owe your business.
Differences between accounts receivable and accounts payable
Accounts payable helps ensure that your business doesn’t fall behind on any payments that are due. It also makes your liabilities (e.g., debts) more transparent and therefore easier to accurately project your cash flow. By clearly seeing how much you owe at any given time, you can make better decisions around spending, pricing, and negotiating with suppliers.
Accounts payable should record the following information:
- The biller’s name and account number, if applicable.
- The invoice number.
- The type of expense (e.g., overhead, inventory, one-time, recurring, etc.).
- The date the invoice was received.
- The payment deadline.
- The status of the payment.
Accounts payable is also an important function in the case of an audit. As a result, you should keep records of purchase orders, invoices, contracts, and agreements with your vendors and contractors as part of your accounts payable function.
Accounts receivable is the other side of the equation. Tracking how much money is owed to your business ensures that you’re earning a healthy amount and covering your costs. Usually, accounts receivable has a two-month repayment window. Generally speaking, there are three types of accounts receivable:
- Notes receivable: This account type uses a promissory note to promise payment will be made within one year, rather than the typical two months. The promissory adds a legal component to your outstanding debt, helping ensure you receive payment.
- Trades receivable: This account type refers to a business asset. “The difference between a Trades Receivable Account and accounts and notes receivable is that it is a direct result of company sales. When a customer buys a good or service and is extended short-term credit in which to repay the loan, this is listed as a trades receivable entry in the current trades receivable account,” wrote Freshbooks.
- Bad debt: If the customer or buyer can’t make the payment, you may have to write their account off as bad debt. This means you lose out on the income; however, there are tax credits that can help offset this loss.
Improve your AP process with automation, so you can eliminate errors, ensure automatic backups, and improve efficiency. You can even schedule bill payments on a particular date, based on your anticipated cash flow.Mercy Johny, Zoho Books
How AP and AR impact cash flow
Both AP and AR are worth understanding in order to get a handle on your healthy cash flow. Without clear information from these accounts, it will be difficult to budget, write financial projections, and see whether your business is operating at a profit or loss.
Accounts receivable directly drives cash inflows. When your customers pay their invoices, cash comes into your accounts. If AR is high and collections are slow, your company is owed money but doesn't have it yet, which can strain cash flow even if your business is profitable on paper.
Accounts payable reduces cash on hand. Each time you pay your suppliers, money leaves your account. Stretching payment terms (paying later) preserves your cash. Managing AP strategically means finding the right balance to give your business flexibility. Ideally, your business collects from customers faster than it pays its suppliers. When that balance flips, companies can find themselves cash-poor despite strong sales, which is one of the most common causes of business liquidity problems.
Best tools to manage AP and AR for small businesses
There are dozens of tools that can help you manage your small business accounting, and it’s worth experimenting with free trials before you invest in any solution. Ratings on Gartner, Capterra, and TrustRadius recommend these tools for small and mid-sized enterprises:
As you explore your options, look for AR/AP software that automates invoicing, bill capture, payment reminders, and approvals to cut manual work and errors. It should provide real-time cash flow visibility, clear AR/AP aging and reporting, and strong audit trails with role-based permissions. Finally, it needs smooth two-way integration with your accounting system, support for local banks and tax rules, and an interface that non-accountants can use confidently.
Common mistakes in managing AP/AR and how to fix them
Unfortunately, AP/AR has traditionally been a manual process, leaving it prone to error. Even without data entry mistakes, there are some tactical errors that small businesses make that can cost money.
First, consider your approach to extending credit. On one hand, this can be a strategic way to build closer relationships with certain customers. On the other hand, it can mess up your cash flow. "Offering credit can make payments easier for your customer, but providing a credit policy to anyone requesting it can lead to non-payments by negligent customers," wrote Zoho Books. "[Review] your credit policy regularly and only extend credit to customers who are likely to pay you back."
It’s also wise to offer a range of payment options so customers have no reason not to pay on time. Implement the tools that allow you to seamlessly accept cash, checks, credit cards, online payments, or transfers. Consider adding a subscription option or recurring payments for repeat purchases.
As far as accounts payable, the same principle applies. Automate as much as you can on your side to make sure payments are made on time. “Improve your AP process with automation, so you can eliminate errors, ensure automatic backups, and improve efficiency. You can even schedule bill payments on a particular date, based on your anticipated cash flow,” wrote Zoho Books.
Make sure you build a system that includes checks for late payments and duplicate payments and that flags potential fraud. The right accounting software can meet all of these needs.
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