Defining Accounts Receivable
Accounts receivable (AR) is an accounting term that refers to the money owed to a business by the customers for goods or services provided but not yet paid for.
What’s covered in the article
The unpaid invoices are recorded as an asset on the company’s balance sheet, signifying an expectation of future cash inflows.
The working of accounts receivable is closely tied to the payment terms agreed upon between the business and its customers.
A business usually extends credit to the customers, allowing them to receive goods or services before making a payment, thus creating accounts receivables. It is a common practice in various industries to facilitate smoother transactions and to build a loyal customer base.
It also necessitates keeping track of outstanding invoices to ensure timely payments. The management of accounts receivable involves several steps, from invoicing clients for goods or services rendered to receiving payment. The cycle begins when a client receives an invoice and ends when the client pays it off, settling their outstanding balance.
By understanding the intricacies of accounts receivable, businesses can better manage their cash flow, extend appropriate credit terms, track payments, and ensure the business can meet its short-term obligations.
Accounts Receivable Process
The accounts receivable process starts with the sale of goods or services to customers on credit terms. Once a transaction is completed, an invoice is generated and sent to the client, marking the beginning of the accounts receivable cycle.
The invoice specifies the accounts receivable balance, the due date for payment, and other terms.
The accounts receivable balance is entered as a current asset on the balance sheet, indicating the amount clients owe to the business. Accountants must update AR records at the end of each accounting period to reflect payments received and any adjustments for bad debts.
Businesses must keep track of the due dates and unpaid invoices and follow up with certain customers who have overdue accounts.
The accounts receivable process also includes provisions for bad debts. Bad debts are amounts that are unlikely to be collected and need to be written off.
Identifying bad debts early in the accounting period can help businesses take appropriate measures, such as turning the accounts receivable (AR) over to a collection agency.
Payment collection is the final step in the accounts receivable process. Payments received are recorded, and the accounts receivable balance is adjusted accordingly. Some businesses also offer discounts or incentives for early payments to encourage the timely settlement of accounts.
Need to Track Accounts Receivable
Accounts receivable is not just an asset account on the balance sheet but a dynamic component that requires constant monitoring and management for business success.
When clients owe money for goods or services, these amounts are recorded in the asset account, known as accounts receivable, representing the money typically collected within a short period and quintessential for meeting short-term obligations.
When a business extends credit to a customer, it essentially invests resources with the expectation of future payment. Failure to manage accounts receivable asset account effectively can result in liquidity issues, making it challenging to cover operational costs or invest in growth opportunities.
Another compelling reason is the risk of bad debt. While extending credit can attract more customers, it also exposes the business to non-payment risk. Monitoring average accounts and identifying potential bad debts early can help in taking timely corrective actions, such as tightening credit policies or employing collection agencies.
Tracking A provides valuable insights into customer behavior like patterns in payment timelines can indicate customer reliability, helping businesses make informed decisions on extending or restricting credit terms.
Tracking every account receivable is indispensable for effective cash flow management, risk mitigation, and informed decision-making.
Accounts Receivable Turnover Ratio
The net credit sales are divided by the average accounts receivable for the given period to arrive at the accounts receivable turnover ratio, representing the amount the company anticipates collecting.
The formula for the turnover ratio:
Accounts Receivable Turnover Ratio= Net Credit Sales/ Average Accounts Receivable
Components of the Formula:
- Net Credit Sales: This refers to the total credit sales minus any returns or allowances. It is essential to use net credit sales rather than total sales to get an accurate measure of the money that is expected to be collected.
- Average Accounts Receivable: This is calculated by adding the beginning and ending accounts receivable for a specific period, usually a year, and dividing by 2. The average accounts receivable gives a more balanced view of the accounts that are expected to be collected during that period.
The ratio measures the number of times accounts receivable are turned into cash over a set period. This is crucial for understanding the liquidity and efficiency of the company’s credit policies.
A high turnover ratio is generally a positive indicator, signifying that the company is efficient in converting its accounts receivable into cash. It suggests that customers pay their invoices promptly, reducing the day’s sales outstanding and minimizing the risk of bad debt.
A low ratio could be a red flag, indicating potential issues such as delayed customer payments or an excessive amount of money tied up in accounts receivable.
The accounts receivable turnover ratio helps in identifying how quickly the average number of accounts is being paid off, thereby providing insights into the company’s credit policies and customer behavior. For instance, a declining ratio over time could signal that customers are taking longer to pay, affecting the company’s cash reserves and increasing the risk of bad debt.
Examples
Example 1
A retail business specializing in electronics has net credit sales of $500,000 for the year. The average accounts receivable for the same period is $50,000.
Accounts Receivable Turnover Ratio=500,000/ 50,000=10
A ratio of 10 is excellent and suggests that the company is efficient in collecting payments. It indicates that the retail business successfully turns its accounts receivable into cash 10 times a year, which is beneficial for liquidity and minimizes the risk of bad debt.
Example 2
A manufacturing company has net credit sales of $400,000 for the year. Their average accounts receivable stands at $100,000.
Accounts Receivable Turnover Ratio=400,000/ 100,000=4
A ratio of 4 is moderate and suggests that the company turns its accounts receivable into cash four times a year. While not as efficient as the retail business in Example 1, this is still a healthy ratio, indicating that the company has reasonable credit policies and collection processes.
Accounts Receivable Ageing
Accounts receivable aging is a methodical approach to understanding the financial health of a company’s receivables. This process involves categorizing all unpaid invoices or accounts based on their age.
The primary aim is to identify invoices that are overdue and require immediate attention.
The aging report is usually broken down into columns that represent different time frames, often in increments of 30 days. These columns help businesses pinpoint exactly how long an invoice has been outstanding, enabling them to take appropriate action.
For instance, invoices that have been unpaid for 30-60 days may require a simple reminder, while those exceeding 90 days might necessitate more stringent collection efforts.
It also aids in making informed decisions about extending credit to customers and helps in prioritizing collection activities.
Impact on Cash Flow and Company’s Financial Health
The impact of account receivable on cash flow and a company’s financial health cannot be overstated. When customers owe money for goods or services, these amounts are recorded in the revenue account, directly affecting the company’s cash flow.
Efficient management of accounts receivable ensures that the company has enough cash to meet its short-term obligations, which are often recorded in the liability account on the general ledger.
A high volume of unpaid invoices can lead to cash flow issues, affecting the total value of the company’s assets and its ability to invest in growth opportunities or even meet operational costs.
Prompt cash payments from customers can significantly improve liquidity, allowing the company to take advantage of new business opportunities or settle its accounts payable in a timely manner.
Poor management can result in a high volume of bad debts, which need to be written off, affecting the total accounts and, ultimately, the company’s bottom line.
Businesses must adopt effective strategies for invoice generation, setting payment terms, and ensuring that customers pay within the stipulated time frame to maintain a healthy cash flow and robust financial standing.
Challenges in Accounts Receivable Management
- Inaccurate Invoicing: Errors in invoices can lead to disputes, delaying the time it takes for customers to pay and affecting the company’s cash flow.
- Late Payments: Despite having clear payment terms, some customers may not pay on time, affecting the company’s ability to settle its accounts payable and other financial obligations.
- Complex Payment Processes: Companies often have to deal with complex payment processes that involve multiple steps, from invoice generation to receiving payment. This complexity can lead to delays and errors, affecting the overall efficiency of accounts receivable management.
- High Volume of Transactions: For businesses with a high volume of transactions, keeping track of each invoice and payment can become a cumbersome task. This can lead to missed follow-ups and, ultimately, unpaid invoices.
- Customer Credit Risk: The company must assess the creditworthiness of each customer, which can be time-consuming and may not always be accurate, leading to bad debts.
- Resource Constraints:An effective account receivable management requires dedicated resources for tracking, follow-up, and reconciliation. Many small businesses may not have the necessary resources, making it challenging to manage accounts receivable efficiently.
- Regulatory Compliance: Companies must also ensure that their AR processes are in compliance with local and international financial regulations. Non-compliance can result in penalties and can complicate the process of receiving payment from international customers.
- Technological Challenges: The lack of advanced tools and software can also pose a challenge in efficiently managing accounts receivable, especially for companies still relying on manual methods.
Tips to Improve Accounts Receivable Cycle
Implement Automated Invoicing Systems
One of the most effective ways to improve the accounts receivable cycle is by implementing automated invoicing systems. Automation not only minimizes human error but also speeds up the invoicing process, enabling quicker payments from customers.
Establish Clear Payment Terms
Clearly defined payment terms are crucial for ensuring timely payments. Make sure to communicate these terms effectively to your customers at the beginning of the transaction. This sets the expectation for when the payment is due and can help in reducing late payments.
Regularly Review Accounts Receivable Aging Reports
Regularly reviewing accounts receivable aging reports can provide valuable insights into which accounts are overdue and require immediate attention. This allows the company to focus its collection efforts on high-risk accounts, thereby improving cash flow.
Offer Multiple Payment Options
Offering different payment options enables customers to settle their invoices. Whether it’s online payments, bank transfers, or credit card payments, the easier you make it for customers to pay, the faster you’ll receive payment.
Implement a Follow-Up Procedure
A structured follow-up procedure can significantly improve the accounts receivable cycle. Automated reminders and personalized follow-up emails can prompt customers to make payments on time, reducing overdue accounts.
Conduct Credit Checks
Before extending credit to new customers, conducting thorough credit checks is advisable. This helps assess the risk associated with the account and can prevent potential bad debts.
Train Staff
Well-trained staff can be your biggest asset in managing accounts receivable effectively. Regular training sessions can equip them with the necessary skills to handle various scenarios, including dispute resolution and negotiation techniques.
Conclusion
Managing accounts receivable is important for maintaining a healthy cash flow and financial stability for any business. By understanding its intricacies and implementing effective strategies, companies can mitigate risks, improve liquidity, and pave the way for sustainable growth.
Using accounting software like Akounto helps you organize, manage and track your accounts receivable. Visit Akounto’s website to know more.
