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What is Accounts Receivable? The Ultimate Guide To AR

by | Feb 23, 2023 | 0 comments

Managing accounts receivable is an integral part of a business’s financial management. It’s all about efficiently tracking and collecting customer payments to ensure a smooth cash flow that meets operational and financial obligations.

In this article, we will delve into the importance of accounts receivable management, highlighting its relevance regardless of the business size. But that’s not all—we’ll also unveil practical strategies and tips on managing your accounts receivable effectively. By implementing these best practices, you can pave the way for a healthier cash flow that sets your business up for success.

What are accounts receivable?

Accounts receivable (AR or A/R) is a term used in accounting to refer to the money owed to a business by its customers for products sold or services rendered on credit. In simpler terms, it is the money your business expects to receive from your customers.

AR is recorded as an asset on a business’s balance sheet, representing a claim against the business’ customers for payment.

How accounts receivable work?

To understand how accounts receivable move within an organisation and their importance in the business, first, you must look at the accounts receivable process. Knowing the significant differences between accounts receivable and accounts payable is also essential, as these two accounts are connected and can significantly impact your cash flow.

the accounts receivable process or order to cash process illustrated as an infographic

The accounts receivable process

The accounts receivable process is crucial to a business’s financial management. It refers to your company’s systematic approach to handling and collecting outstanding customer payments promptly and efficiently.

Also known as the Order-to-Cash (O2C) process or O2C cycle, the process varies based on the type of business. Generally, it consists of the following steps:

Top 10 tips to improve your accounts receivable process

1. Processing credit applications

Your business needs to develop a credit application process and assess the applicant’s creditworthiness when offering goods or services on credit. You must also establish terms and conditions that comply with existing laws on credit on your credit application.

Other factors to include in your credit application form are interest rates and payment terms or the number of days you expect payment from the issuance of the invoice. The most common is 30 days, but businesses also use net terms of 60 days or more. Collecting the debt on time is crucial for your business’s cash flow and capital needs.

Business Credit Application Template : What should your business include in a B2B Credit Application form?

2. Generating an invoice

When a customer places an order and buys something on credit, your business should create an invoice promptly. The invoice should include information about the transaction, such as the amount owed and payment terms.

3. Recording the invoice

Log the invoice in your bookkeeping software and adjust the accounts receivable balance to match the amount the customer owes. You can automate this task by  linking your accounting system or ERP with accounts receivable software.

4. Sending the invoice to the customer

After the invoice has been generated and recorded, the next step is to send the invoice to the customer, along with any other required documentation, such as a statement of account.

Using electronic means of sending invoices – thru email or SMS – helps ensure invoices are sent on time. You can also utilise online payment portals to make invoices and statements of accounts accessible to your customers.

5. Following up with the customer

If the invoice becomes overdue, you should follow up immediately to remind customers of their outstanding balance and request payment. Leveraging automation as part of your communications workflow is crucial at this point.  With an automated workflow, you get notified of any past-due invoices that will automatically trigger the sending of payment reminders according to your set rules.

Automation of communications saves your team time and eliminates the need to pursue payments constantly.

6. Recording the payment

When the customer makes a payment, you should record the payment in your accounting system to reflect the reduced amount owed by the customer. Integrated AR tools can make this process easier by automatically writing back payments to your ERP.

7. Reconciling the accounts

Compare the balances in your accounts receivable ledger with those in your general ledger. This helps ensure that the information in your accounting system is accurate and up-to-date.

Fortunately, current accounts receivable software has streamlined the reconciliation process. With advanced automation capabilities, these systems can reconcile invoices as soon as payments are received, eliminating the need for manual reconciliation.

In addition, modern accounts receivable software can integrate with your accounting system, creating a single source of truth for your financial data. This integration can improve data accuracy and reduce the risk of errors and discrepancies in your financial reporting.

8. Reporting

Generating reports to track your AR balance, outstanding invoices, and payment history is crucial in AR management. These reports provide valuable insights into the financial health of your business and help you identify potential issues with your accounts receivable process.

Implementing accounts receivable software can help you establish a well-designed accounts receivable process. By automating your approach to AR, you can ensure your business collects customer payments promptly and efficiently, which is essential for maintaining healthy cash flow and financial stability.

Accounts receivable vs accounts payable

illustration listing differences between accounts receivable and accounts payable

Accounts receivable (AR or A/R) is the money owed to a business by its customers for products or services provided. AR represents an asset on a company’s balance sheet, representing customers’ expected future cash inflow from credit sales.

On the other hand, accounts payable (AP) refers to the money a business owes to its suppliers or vendors for products or services it purchased on credit. It represents a current liability on the business’s balance sheet, an amount it expects to pay in the future.

AR collection can directly impact your business AP, affecting its cash flow, credit rating, and supplier relationships. By managing your AR collection process effectively, you can improve your ability to pay obligations and maintain good relationships with your suppliers.

Why are accounts receivable important for businesses?

Accounts receivable are important for businesses for several reasons:

It helps ensure a healthy cash flow

An effective AR process can help a business forecast its cash flow more accurately by providing visibility into expected cash inflows. This can help the business better manage its cash resources, plan for future investments, and avoid cash shortages.

It is critical to managing working capital

Accounts receivable are also an essential part of a business’s working capital as it represents the money you expect to receive in the near future that you can use to fund current operations.

How to manage working capital and improve cashflow in your business

It indicates a business’ creditworthiness

Accounts receivable can also indicate a business’s creditworthiness. A business with a high level of accounts receivable shows that it has a healthy customer base and can generate sales. This can make the business more attractive to investors and lenders.

It helps establish good customer relationships

Businesses can foster goodwill and loyalty by providing customers with flexible payment terms and responding to their payment inquiries.

Make Your Working Capital Work for You: Ways to Optimise Your Accounts Receivable

What does an accounts receivable on a balance sheet indicate?

Accounts receivable are part of the Current Assets in the balance sheet and are essential to a business’ working capital.

When analysing your business’ balance sheet, assessing the level of accounts receivable can offer valuable insights into your sales and collection practices.

A high level of accounts receivable might indicate that your business is making substantial sales on credit, which can be a positive indicator of sales growth. However, it can also imply that you face challenges collecting customer payments, potentially impacting cash flow and overall financial stability.

Therefore, it’s crucial to scrutinise the accounts receivable balance. If it increases significantly over time, it may be necessary to investigate your credit policies, collection efforts, and customer base quality.

To better understand accounts receivables and the effectiveness of your collections, you can compute the accounts receivable ratio.

 

What is the accounts receivable turnover ratio?

illustration and text explaining the accounts receivable turnover ratio formula

The accounts receivable turnover ratio shows how often a company can convert its receivables into cash in a given period.

The formula for calculating the accounts receivable turnover ratio is:

Accounts Receivable Turnover Ratio = Net Credit Sales / Average Accounts Receivable

Where Net Credit Sales is the total credit sales made during a period, and Average Accounts Receivable is the average amount of accounts receivable during that period.

A higher ratio indicates that your business can collect its accounts receivable quickly, which is generally favourable. Conversely, a lower ratio can indicate challenges in collecting payments on time.

Accounts receivable turnover ratio: How to interpret and improve it

Best practices for managing accounts receivable

Effective accounts receivable management is essential for maintaining a healthy cash flow in a business. It is vital to keep track of debtors and ensure that payments are collected promptly.

Here are some best practices for managing accounts receivable and reducing the amount of time accounts receivable are outstanding:

1. Establish clear credit policies

Set up clear credit policies that define your payment terms, credit limits, and the consequences for late or non-payment. An online credit application system can help ensure you don’t miss these details during onboarding.

2. Perform credit checks

Before extending credit to customers, perform a credit check to assess their creditworthiness and ability to pay. Use business credit score data to help you make informed decisions on approving credit applications. Practising your due diligence on credit checks can also help you gain insights on your customers’ credit and payment behaviour.

How an enhanced credit application process can protect your business from bad debts

3. Invoice promptly and accurately

Ensure that you invoice promptly and accurately. Late or inaccurate invoices can cause delays in payment and lead to disputes.

4. Follow-up on overdue payments

Regularly follow up on overdue payments. Send reminders, make phone calls, and escalate collection efforts to a debt collection service if necessary.

Related blog post: https://ezycollect.io/blog/overdue-invoices-templates-for-email-and-sms-reminders/

5. Offer multiple payment options and digital payment method

Offer multiple payment options to your customers, such as credit cards, online payments or auto-debit payments. Providing convenient options for your customers to makes it easier for customers to pay you, leading to less late payments and a better customer experience.

Electronic payment methods, meanwhile, can speed up payment processing and reduce the time it takes for funds to reach your account.

6. Monitor receivables

Monitor your accounts receivable regularly and track the aging of each account to identify potential delinquencies. You can use an accounts receivable template to manually track receivables on a spreadsheet.

Ideally, you would have to implement accounts receivable software to automatically monitor and update your receivables. You can also sync the software with your accounting system to make this vital task easier for your team.

Managing AR: Free Accounts Receivable template vs. AR Automation software

7. Establish a collection policy

Establish a clear and consistent collection policy outlining the steps to collect overdue payments. A collection policy will guide your team on the next steps to take when dealing with overdue payments and allow your team to maintain a consistent approach on collections.

8. Analyse accounts receivable turnover ratio

Analyse your accounts receivable turnover ratio regularly to identify trends in your order-to-cash cycle and highlight areas for improvement in your collections process.

Top 10 tips to improve your accounts receivable process

How to improve your accounts receivable process

Managing your accounts receivable effectively can help you maintain a steady cash flow and reduce the risk of bad debts. Your business can improve its accounts receivable process in several ways:

1. Automate invoicing

Automation can speed up the invoicing process and allow you to send out invoices immediately after a sale is made. This reduces customers’ time to receive their invoices and can help ensure that payments are made on time. Automation also helps reduce errors that can cause disputes and further delay payments.

2. Automate follow-ups and payment reminders

Automating sending payment reminders to customers saves time chasing payments and reduces the risk of missed or late payments. It ensures no invoices are missed to collect payments.

3. Offer early payment discounts or credit term extensions

Offering discounts to customers who pay early can effectively encourage timely payment.

Another viable option is to offer credit term extensions for customers who sign up to pay via direct debit. Encouraging customers to provide direct debit authority help streamline the payment process for both parties, reduces administrative burden, and minimises the risk of late or missed payments.

4. Implement a payment gateway

Implementing a payment gateway that allows customers to pay from your e-commerce store can make it easier for them to make payments, reducing payment delays. Integration with your accounts receivable automation software ensures payment data is centralised in one location for all your customers’ invoices.

New payment gateway: ezyCollect Payments x WooCommerce integration

5. Conduct regular credit checks

By routinely evaluating the creditworthiness of your customers, you can identify any potential issues or red flags that indicate a higher likelihood of non-payment. This allows you to take appropriate measures to reduce the overall risk to your accounts receivable.

Integrating business credit scores into your credit monitoring process allows you to identify customers with a higher risk of delinquency or non-payment. Credit checks enable you to implement proactive collection strategies, such as closer monitoring, setting stricter payment terms, or requesting additional collateral or guarantees. Conversely, you can give more flexibility or offer discounts to customers with better credit scores, strengthening customer relationships.

6. Monitor acccounts receivable aging

Monitoring your accounts receivable aging regularly can help you identify and address overdue accounts. Ensure you can view your aging receivables in a dashboard in your accounting or AR system to monitor accounts that need attention efficiently.

7. Personalise customer communication

Personalised follow-up messages to customers help build stronger customer relationships and encourage timely payments.

Regularly communicating with your creditors helps build a good working relationship. It lets you keep them informed about any changes or updates in your business that may impact payment schedules or terms. Similarly, staying informed about any changes on their end helps you anticipate and plan accordingly.

8. Consider debt collection services

When you encounter aged receivables that seem challenging to collect, it’s essential to consider engaging a debt collection service before writing them off as bad debts. These services specialise in debt recovery and can assist you in strategising the best action to collect outstanding debts.

By partnering with a debt collection service, you can benefit from their expertise navigating the collection process. They can provide valuable insights, advice, and customised strategies tailored to each debtor situation. This can significantly increase your chances of successfully recovering aged receivables and reduce the burden of collection efforts.

 

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Conclusion

In summary, accounts receivable is important for businesses because it helps maintain cash flow, provides working capital, indicates creditworthiness, and helps build and maintain customer relationships.

Managing accounts receivable effectively ensures your business is paid promptly and has enough cash to fund your growth and improve financial stability.

AR automation software can help you manage your accounts receivable process efficiently, so you can focus on what you do best – growing your business. Speak with one of our AR experts today to learn about options for your business.

 

Accounts receivable FAQs

Q- What can I do to make people pay faster?

Implementing automation in your accounts receivable process is the easiest way to get paid faster. An accounts receivable software lets you automate sending payment reminders via email or SMS and allows you to offer online payments with multiple payment options to make it easier for your customers to pay you.

Q – What is an Accounts Receivable Aging Report?

An accounts receivable aging report is a financial report that summarises the outstanding customer invoices and payments in your business. The purpose of the accounts receivable aging report is to help your business identify overdue accounts and allow you to take action to collect outstanding balances. The report typically lists all customer accounts with balances due and categorises them according to the time they have been outstanding.

Q – Is accounts receivable an asset?

Yes, accounts receivable are considered an asset on a company’s balance sheet. It represents the money your customers owe your business for products or services provided but still need to be paid for. It is a type of current asset because it is expected to be converted into cash within one year from the date of the balance sheet.

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