The best way to keep your cash flowing and maintain financial stability is to effectively manage accounts receivable.
A company’s accounts receivable (AR) are its outstanding invoices and money owed to its clients. Essentially, it’s a claim for payment held by a business for products or services provided on credit.
Ahead, you’ll learn the importance of accounts receivable, the AR process, and strategies to manage and reduce AR turnover.
Table of Contents
- What is accounts receivable?
- How does an account receivable work?
- Advantages of recording accounts receivable
- Accounts receivable turnover ratio
- Managing accounts receivable
- Accounts receivable aging schedule
What is accounts receivable?
Accounts receivable is an asset account that tracks the money due to a business from clients or other debtors. Essentially, the number in this account represents sales made by extending credit to a customer up until the point that the business receives the expected funds.
Understanding accounts receivable
Accounts receivable is considered a current asset account, meaning that it only records funds with a due date within one calendar year.
As such, it represents short-term obligations: If you initiate a five-year contract under which a customer will pay a set amount annually, the receivable balance listed on your balance sheet would only include the amount due within one year. When accounts receivable aren’t paid, some companies send them to a third-party collection agency to recover the debt.
Accounts receivable is used under an accrual accounting method, the accounting system in which income and expenses are entered when a transaction occurs, not when funds are received or debited.
Accounts receivable vs. accounts payable
Accounts receivable is key to managing cash flows: in addition to knowing the amount of money you have, it’s helpful to know the amount of money you will have in the near future.
It’s also helpful to know the amount of money you owe, which is where accounts payable (AP) comes in. Accounts payable refers to money that a business owes to its creditors.
It can include material costs, overhead such as facility and utility fees, and contractor agreements. This number is also recorded on your balance sheet under accounts payable. AP is essentially the inverse of AR.
How does an accounts receivable process work?
Recording (and collecting on) accounts receivable follows a simple process:
- A customer requests to purchase goods or services via a signed contract or purchase order.
- Goods or services are delivered.
- The merchant provides the customer with an invoice and notes the amount of money due as a credit in accounts receivable.
- The customer pays the balance and the merchant debits that amount from accounts receivable and records it as a deposit.
Let’s say that you run an ecommerce business that sells handmade clay tiles, and a client submits a purchase order for 300 square-cut tiles, priced at $1.50 each, for a total of $450.
The purchase order will contain payment terms and specify a due date for funds, which is expressed from the date of invoice—“net 60,” for example, means that funds are due within 60 days of the date that the invoice is issued.
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You’d accept the order, make and ship the tiles, and invoice the customer for $450, plus tax and shipping, as applicable. The total amount your customer owes would then be recorded as a credit on your balance sheet under accounts receivable.
Once this sum is paid, the total would be deducted from accounts receivable and recorded as a deposit under revenue.
Advantages of recording accounts receivable
There are many benefits to recording accounts receivable, from allowing you to extend credit to customers to measuring how efficiently you are collecting the money owed to your business. It can also help you manage cash flow and streamline your accounting systems, freeing you up to focus on running your small business.
Improved customer relations
Extending credit to customers is made possible by a system that tracks the amount of money they owe. By recording credits in accounts receivable, business owners can make sure that customers pay their bills without being forced to collect cash upfront—and extending credit lowers the barrier to purchase, increasing your sales.
Extending credit also builds goodwill: Requiring upfront payment can be cumbersome for both you and your customers, and clients are sometimes hesitant to pay for a good or service that they have yet to receive.
Streamlined accounting systems
Tracking accounts receivable can help you organize your balance sheet and streamline your invoicing processes.
A customer payment appears on your balance sheet three times: once as a credit to receivables, once as a debit from receivables, and once as a credit to revenue. You can easily cross-reference your transactions.
By keeping track of your outstanding debt, an organized balance sheet also helps you collect money owed to you. It also helps you analyze days sales outstanding (DSO), which is the average number of days it takes to collect payment after a sale is made.
Ecommerce accounting software can even automate parts of this process by automatically crediting accounts receivable when an invoice is issued and debiting accounts receivable (and crediting revenue) when a payment is received.
Cash flow management and measuring liquidity
Your accounts receivable balance is a critical indicator of your company’s financial health. Without it, your balance sheet can’t provide an accurate picture of your liquidity. It can also help you manage cash flows, allowing you to meet your obligations while operating with a smaller amount of cash on hand.
Risks associated with accounts receivable
- Cash flow problems: Delayed or uncollected receivables can result in insufficient cash flow, leading to difficulties in meeting financial obligations.
- Higher financing costs: A company with high accounts receivable balances may need to rely on external financing, increasing interest expenses.
- Loss of income: Uncollected receivables, or doubtful accounts, may eventually become uncollectible, resulting in a loss of income for the company.
- Credit risk exposure: Unmonitored credit sales can lead to excessive credit risk exposure, increasing the likelihood of non-payment.
Accounts receivable turnover ratio
The accounts receivable turnover ratio is a financial metric that measures a company’s effectiveness in managing its accounts receivable. A higher ratio indicates more frequent collection of receivables, while a lower ratio suggests less efficient management of credit sales.
To calculate the accounts receivable turnover ratio, use the following formula:
Accounts Receivable Turnover Ratio = Net Credit Sales / Average Accounts Receivable
- Net Credit Sales =Total sales on credit minus returns and allowances
- Average Accounts Receivable = The average of accounts receivable balances at the beginning and end of the period
If your company sells $100,000 on credit per quarter and the average balance of accounts receivable in that year is $10,000, your accounts receivable turnover ratio is 10:1, or 10.
If your average accounts receivable balance over this same period is $120,000, however, your accounts receivable turnover ratio is less than one, coming in at 0.8. If this ratio doesn’t increase, you’re actually losing money over time, even if business is booming—and the more you increase sales on credit, the more money you’ll lose.
Combined with your accounts receivable balance, your accounts receivable turnover ratio gives you a strong picture of your business’s overall financial outlook.
Managing accounts receivable
Implementing effective strategies for managing accounts receivable is essential to ensure timely collections and maintain healthy cash flow.
- Establish a clear credit policy: Set criteria for extending credit to customers, including credit limits, payment terms, and penalties for late customer payments.
- Perform credit checks: Regularly review customer credit histories to minimize the risk of non-payment.
- Send invoices promptly: Issue invoices as soon as goods or services are delivered, to ensure timely payment.
- Implement a follow-up process: Establish a process for following up on overdue invoices, including reminders, collection calls, and escalation procedures.
- Offer incentives for early payment: Encourage customers to pay early by offering discounts or other incentives for prompt payment.
- Monitor accounts receivable turnover: Regularly analyze accounts receivable turnover to identify trends and assess the effectiveness of your credit policies.
- Review and update your credit policies regularly: Periodically assess your credit policies to ensure they remain effective and adapt them as needed based on changing economic conditions and customer behavior.
Accounts receivable aging schedule
An accounts receivable aging schedule is a financial statement that categorizes outstanding receivables based on the length of time they have been outstanding.
This report helps businesses identify overdue accounts, assess credit risk, and prioritize collections efforts.
An accounts receivable aging schedule typically includes the following columns:
- Customer name
- Total outstanding balance
- Current (not yet due)
- 1–30 days overdue
- 31–60 days overdue
- 61–90 days overdue
- Over 90 days overdue
Get the money owed to you by managing accounts receivables
Account receivables is a critical part of an accrual accounting system, allowing business owners to manage cash flow and keep an accurate, organized balance sheet while extending credit to customers.
In conjunction with accounts payable, it allows your accounting team to keep an eye on long-term financial prospects and provides you with metrics to make sure customers pay their bills on time.
If you’re new to accrual accounting, recording credits for money you don’t actually have in hand can feel a little nerve-wracking. An experienced accounting partner (or modern accounting software) can help you confidently track these transactions and use the information to plan for the future.
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Accounts receivable FAQ
What does it mean to be an account receivable?
What is an example of accounts receivable?
What is the difference between AR and AP?
Is accounts receivable an asset or liability?
Accounts receivable is considered an asset because it represents the money that a company expects to collect from its customers for goods or services provided on credit. It’s part of a company’s working capital.