Accounts Payable vs Receivable | How do they interact with cash flow?
Accounts payable and receivable are both accounts that are found on the balance sheet.
In short, accounts payable are debts your business is due to pay within a specific period of time (usually a year).
Accounts receivable are the opposite, they are debts owed to your business and are also expected to be received within a specific period of time (usually a year).
In this article we’ll discuss the difference between payable and receivable. We’ll then go on to discuss their interaction with the cash flow statement.
Understanding what accounts payable and receivable are is relatively simple, it starts to get tricky when you start looking at your cash flow. Understanding this interaction between cash flow and the balance sheet is key to seeing the complete picture – which we’ll discuss in the final section.
What are accounts payable?
Accounts payable are monies that your business owes. This could be to staff, contractors, suppliers etc. It also covers goods and services received on credit.
It comes under current liabilities on the balance sheet.
Current liabilities are short term debts that the business needs to pay within a year. Current liabilities aren’t just accounts payable, they also include staff wages/salaries payable and short term borrowings like loans.
You can read more about current liabilities here.
Accounts payable example
Imagine your business premises has a leaky pipe.
You hire a plumber to fix the leak.
He comes, fixes the leak and then leaves. A few days later he sends you an invoice for £100.
This then sits in your accounts payable until the finance department pays the money to the plumber.
This money now comes out of your accounts payable and is recognised as cash spent on the cash flow (more on this later).
What are accounts receivable?
As you might have guessed by now, accounts receivable are the opposite of accounts payable.
These are monies owed to your business by customers for goods and services that you have delivered, but not yet been paid for.
Because this money is owed to your business, it is classified as a current asset.
Current assets are short term monies owed to you by customers or are assets (like equipment, computers etc.) that can be converted into cash within a short period of time.
You can read more about current assets here.
Accounts receivable example
Imagine you are a plumber and get a call out to fix a faulty ballcock.
You fix the customer’s ballcock and they are happy.
You send the customer an invoice of £100 for your service.
This £100 now sits in your accounts receivable on your balance sheet and is an asset until the customer pays the invoice, at which point it leaves your accounts receivable, enters your bank and is recognised on your cash flow.
The difference between accounts payable and receivable
Essentially, accounts payable and receivable are opposites.
With accounts payable, you are due to pay out money.
With accounts receivable you are due to receive money.
It really is as simple as that.
Just remember that there are two sides to each transaction.
Symmetry between accounts receivable and accounts payable
When you have a transaction between two parties/businesses, there is what is known as symmetry.
Whenever a company records an accounts payable there is a company recording an accounts receivable.
If you take my example from earlier – in this case a plumber was called out to a business, he charged £100.
Until the business paid the plumber, it had £100 in accounts payable, and the plumber had £100 in his accounts receivable.
This symmetry demonstrates the two sides to every transaction.
How do accounts payable and receivable interact with the profit and loss statement?
The profit and loss statement acts similarly to the balance sheet when a transaction is recorded.
Regardless of whether any cash has changed hands, the profit and loss statement will always record a transaction the moment it happens.
In my example earlier, the transaction would appear on both parties’ profit and loss statements the moment the invoice is issued.
This is recorded as either a revenue or an expense, depending on which party is paying and receiving.
If you’re not aware of how the profit and loss registers transactions, this can all appear a little confusing.
The trick is that revenue can be recognised on the profit and loss independently of when cash is paid for that transaction on the cash flow.
This means that profit and loss paints one side of the picture, and makes it essential to also look at your cash flow to get the full picture.
Unsurprisingly, the cash flow records things a little differently to the balance sheet and profit and loss.
How do accounts payable and receivable interact with the cash flow statement?
We know now that when you make a purchase on credit, it enters your accounts payable until you pay it.
This transaction is registered on your balance sheet immediately and your accounts payable increases by the amount you owe.
Where the transaction is not registered immediately is your cash flow statement. The transaction will not be recognised on the cash flow until you actually pay it.
In my plumber example earlier, if the business has the work carried out in January, but doesn’t pay until February, then the transaction will not appear on the cash flow statement until February.
This is because no cash has left the business’ bank account. The cash flow statement will only record transactions when cash has either entered or left the business’ bank account.
Conversely, the profit & loss and balance sheet record their transactions as soon as they happen, regardless of whether cash has changed hands.
This can inevitably lead to confusion, as transactions can appear on your profit and loss but not on your cash flow.
The most important thing to remember is the timing of payments, as that will have the largest effect on when transactions appear on your 3 key financial statements (cash flow, profit and loss & balance sheet).
Perhaps the most important thing to remember, is that accounts payable will decrease your business’ cash flow, whereas accounts receivable will increase it.
The full picture
Looking at each of the financial statements in isolation provides a pretty confusing picture of what is actually going on when you register a transaction.
The profit and loss and balance sheet will register them instantly.
The cash flow won’t register anything until cash has changed hands.
Looking at and understanding all three in unison is the key to unlocking the full picture of your business and its transactions.
Why is this key I hear you ask?
Not only does it demystify the timing of transactions, but by looking at past transactions and when your clients decide to pay, you can forecast when cash will become available from your accounts receivable more accurately.
Amongst other things, this gives you insight into whether you’ll need further funding or whether you’ll have surplus cash that you can invest into the business.
Here’s a quick recap of what we’ve covered in this article:
- Both accounts payable and receivable are found on the balance sheet
- Accounts payable are debts that your business is due to pay within the coming year
- Accounts receivable are the opposite, they are debts that are owed to your business within the coming year.
- The difference between them is simply that one sees you owing debts, the other shows you being owed them.
- There is a symmetry between accounts payable and receivable – when a transaction occurs, one company will be registering it in their accounts payable and the other will be registering it in their receivable.
- Understanding the timing of payments is key to understanding when transactions will hit your accounts payable/receivable and when they will be registered on your cash flow.
Ultimately, the concept of accounts payable and receivable are simple enough to understand.
But where it gets tricky is understanding their impact on cash flow and when this impact happens, which is crucial for getting the complete picture of your business.