The success of a business is often determined by its financial condition. Strategic elements that affect the profit and income such as risk management and investments are often considered in assessing the financial condition. Be that as it may, the financial success of any organization is conditional upon the effectiveness of cash flow management. This is ascertained by accounts payable and accounts receivable, known as A/P and A/R respectively.
What is Accounts Payable?
In simple terms, accounts payable is the money owed by a business. An organization requires several assets to operate such as inventory and communication services. On receiving these assets on credit, a payment will have to be made within a certain term. This is a debt that requires some cash outflow in the future, making it an account payable.
Accounts payable must be managed effectively. A proper knowledge of it helps to understand the amount owed by the operation and the financial situation of an organization. Good accounts payable management ensures that the payments are paid in full within the deadline. Otherwise, it results in increased interest charges and late fees, making it harder to keep the organization operational.
What is Accounts Receivable?
Accounts receivable is the money that a business is yet to receive from its clients. When an organization provides a service or product but the customer has not made the payments, the cash due to the organization becomes an account receivable. Accounts receivable have a major impact on cash flow. It shows that the organization is making sales. As such, the organization can have money but it will take time for the cash to flow in.
What is the Difference between Accounts Receivable and Accounts Payable?
Understanding the difference between accounts payable and accounts receivable is essential for proper bookkeeping.
While accounts payable is the money that is owed by the organization to other entities, the accounts receivable is the money due to the organization.
Accounts payable are created when the organization buys services or goods from vendors or suppliers on credit. As such, other entities get paid. Account receivables are the amounts that the organization can collect due to sales made. Here, the organization in question gets paid.
Accounts payable are always listed as liabilities while accounts receivable are always an asset.
Accounts payable are cash outflow, resulting in the decrease of the organization’s finances. All businesses try to keep their accounts payable to a minimum. Accounts receivable increase the cash but organizations strive to keep them within a reasonable number or they may be strapped for cash.
The Importance of Balancing Accounts Payable vs. Accounts Receivable
While running an organization, the management will certainly be habituated to monitor sales, profits and repeat business. But, it is just as important to keep track of the balance of accounts receivable vs. accounts payable. If ignored, the organization may run out of cash without prior notice.
These two aspects of the books have a major influence on the liquidity of the organization. A liquid organization is one that has enough cash to keep itself operational. In other words, its net working capital is in the positive.
The working capital of an organization is the difference between its assets and its liabilities at the current point of time. In a way, it is the difference between accounts payable and receivable. It is vital to ensure that the net working capital is always in the positive to ensure that the organization can continue to operate. For this to happen, outstanding assets and accounts must be collected while settling the liabilities in a timely manner.
For the management of working capital, it is important to become familiar with two terms, DSO and DPO. DSO stands for Days Sales Outstanding and is the average number of days within which the payments for accounts receivable are collected. DPO is the Days Payable Outstanding and is the average period required for paying invoices and other accounts payable.
Effective management of the working capital requires the DSO to be lower than 45 days. Increasing the DPO and the reduction of the DSO is how the working capital can be improved. In other words, the organization needs to start collecting pending payments from their customers faster while delaying payments to suppliers and vendors.
Understanding the difference between accounts receivable and accounts payable is critical but what is more important is to know how to balance them.
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