What is Accounts Receivable? A guide to understanding AR and its importance

Accounts receivable (AR) is crucial for business success. By managing your AR process effectively, you can improve Your cash flow, increase revenue, and build better customer relationships. AR involves tracking and managing customer payments and outstanding balances. Our comprehensive guide will help you understand what AR is, And how you can optimize your AR process…

What is Accounts Receivable A guide to understanding AR and its importance

What is accounts receivable?

Accounts receivable is the amount due to a business for goods and services already delivered to a customer but not paid for.

Most business entities offer their goods and services on credit and cash. Customers who buy on credit receive the product or service upfront and get an invoice. However, they can pay the invoice after some time, usually between 30 days and 12 months.

During the credit period, the amount owed will remain as a receivable balance on the invoice until the client pays it.

Overall, your business’s receivable accounts show how much cash you are yet to collect from customers and are a reliable indicator of your business’s financial health.

That said, it’s critical to note that accounts receivable don’t just refer to the amount but to the process of collecting the money due to your business. Examples of actions that you can consider AR processes include:

  • Drafting and sending customer invoices
  • Monitoring if invoices have been paid
  • Following up on unpaid invoices
  • Invoice reconciliation

Sounds very much like your general invoicing process? Well, that’s because that’s exactly what AR entails. Some people also call the accounts receivable process invoicing or bills receivable.

Essentially, accounts receivable present themselves as debt or credit extended to your client. However, because the amount is for services or goods delivered, the customer is legally obligated to pay you, making this an asset (not a liability) in your balance sheet.

What are examples of receivables?

Examples of receivables include:

  • Sales made to customers using store credit
  • Subscriptions (bi-monthly, monthly, or sometimes annually)
  • Installment or lay-bye payments
  • Invoiced amounts

All of these count as receivables as the cost to the customer is due after they have already received the goods or services.

Accounts receivable vs. accounts payable

Accounts payable are the opposite of receivables. When a business owes an amount to another party, they are liable to pay that debt.

For example, if you’ve received goods from your supplier but are yet to pay, this amount falls under payables for you and receivables for the supplier.

What are the business objectives of accounts receivable?

There are several business objectives of accounts receivable processes. Some of these include:

Maximizing revenue generation

Your business’ AR is essential for evaluating its profitability and may be among its steadiest revenue generation measures. It is the most precise guide to show you how much money comes into your company.

 When evaluating whether your business is profitable, you can check your receivables plus other assets against your liabilities. 

If you subtract liabilities from assets and the result is positive, your business is profitable.

If not, you’ll need to find ways to increase income. Receivables and other short-term or current assets, like cash payments, are the best way to do this quickly.

Additionally, AR processes help customers pay their bills on time. These processes keep track of outstanding invoices and monitor customers yet to pay, ensuring they settle their unpaid invoices timely. As a result, AR ensures your business maintains a consistent cash flow and thrives.

Reducing bad debt

Customer debts are inevitable when in business. But you can significantly reduce your bad debt losses with the proper accounts receivable invoicing processes.

The best AR processes provide accurate insight into the ideal customers to work with and those who are likely to increase your bad debt expense.

You’ll know which customers have a good history of making timely payments and can choose to extend credit to them only while avoiding high-risk customers.

Your accounts department can also use insight from accounts receivable processes for proper bad debt provision and find ways to cushion your business from financial losses.

Improving customer relations

A good AR system allows businesses to provide excellent customer service to clients. You can personalize how you interact with customers and help them bond with your business.

Building trust in this way increases customer loyalty. Clients will want to continue doing business with you.

Identifying areas for improvement

The information from cash flow reports can help you identify business processes that work well and others that require improvement. You could also get valuable insight to inform your business’s growth strategies by analyzing cash flow reports.

What are accounts receivable metrics and KPIs?

AR metrics and KPIs are the quantitative measures you can use to evaluate the efficiency of your AR processes and assess your broader business process landscape.

Some of the most critical AR metrics to pay attention to include the following:

Accounts receivable turnover ratio

Your AR turnover ratio measures your company’s success in collecting the receivables due to your business. It tracks the number of times a business receives the balance due from owing customers.

The higher your turnover ratio, the more effective your billing processes are in ensuring receivables payment.

A low ratio may mean revising your company’s bookkeeping and collections processes, credit policies, and customer vetting.

To calculate your AR turnover ratio, divide your net credit sales by the average accounts receivable.

AR turnover ratio = net credit sales / average accounts receivable

Days Sales Outstanding (DSO)

DSO is an AR metric that reveals the average time customers take to pay you once you’ve made a sale. It helps you determine the effectiveness of your cash collection strategy.

A low DSO means customers take less time to make their payments. It indicates that your collection strategy works well since your business brings cash faster.

On the other hand, high DSO means customers take longer to pay, and your money remains a receivable balance in your accounts. This may be a cue to adjust your collection strategies to speed up collections.

To calculate your DSO, divide your total accounts receivable by total credit sales, then multiply by 365.

DSO = [Total Accounts Receivable / Total Credit Sales] x 365


Best Possible Days Sales Outstanding

The Best Possible DSO shows the average days your customers take to pay you, assuming they always pay on time.

It may sound the same as DSO. But it’s different in that it considers current accounts receivables only, as opposed to total receivables, which include overdue receivables in DSO.

Best Possible DSO also offers insight into improving your AR processes like DSO.

To calculate the Best Possible DSO, divide the current accounts receivable by the total credit sales, then multiply by 365.

Best Possible DSO = [Current Accounts Receivable / Total Credit Sales] x 365


Average Days Delinquent (ADD)

ADD shows how long your receivables stay overdue on average.

In an ideal situation, you shouldn’t have any overdue accounts. So the closer your ADD is to zero, the better. A low ADD indicates that your business maintains a good cash flow.

Average Days Delinquent = Days Sales Outstanding – Best Possible Days Outstanding


Bad Debts to Sales

Bad debt refers to account receivables that go uncollected. This metric helps you understand the percentage of your business revenue that converts into bad debts. It helps improve your business’s invoicing and collection processes.

A high bad debt-to-sales ratio (above 25%) shows you need to act immediately to start issuing invoices proactively and making regular follow-ups to improve collection.

Always check to ensure your bad debt-to-sales ratio remains below 15% to prevent revenue loss due to writing off customer debts.

Bad Debt to Sales Formula: Uncollected Sales / Annual Sales x 100


Collective Effectiveness Index (CEI)

CEI helps you measure your AR team’s efficiency in collecting receivables in a specific period, say one month or year.

Most average businesses aim to attain a 100% CEI. Meaning the AR team collected all money owed by clients at a certain period. But this might not be easy to achieve. Any percentage from 80% and above shows your team is doing well.

You can optimize your CEI by:

  • Listening and communicating with debtors properly
  •  Making consistent follow-ups
  • Ensuring there are no invoice errors when invoicing to prevent client disputes, which often delay payment


Operational Cost Per Collection

Operational Cost Per Collection measures how much your business spends on collecting AR.

It’s an essential KPI that enables you to analyze the operational costs of all collections management activities. These may include the costs of all AR software and communication channels.

The lower the operational costs, the higher your profit margins. 

Companies can use accounts receivable automation solutions to reduce AR costs and keep their business expenses in check.


The accounts receivable process

The AR process is a detailed and well-documented process that involves five distinct steps:

Credit creation

The company creates the credit terms and decides how much credit they’ll grant customers. Determining this may require checking the customer’s credit history and getting a feel of their credit utilization rate so you can be sure they’ll make their payments within the required time.

Invoicing 

Invoicing happens after you deliver the goods or services to the customer. You can do this manually by preparing and sending a paper bill through the mail or electronically.

Electronic invoices may include different formats like emailed bills or using invoices generated and sent through invoice accounts receivable software.

We recommend automating this process by integrating reliable invoicing accounts receivable software with your existing accounting software.

That’s because invoicing is time-sensitive work – the faster a customer gets their invoice, the higher the chances of them making timely payments.

Payment acceptance 

You can receive customer payments through different channels, including wire transfers, virtual credit cards, ACH payments, or paper checks.

We recommend setting up various online payment channels to make it easy and convenient for customers to pay their debts.

But remember, setting up and running each online payment option comes with its costs. Ensure your business can handle all the costs of your chosen payment methods.

Cash application 

The cash application process involves acknowledging you’ve received a customer’s payment and marking their invoice as paid.

It can be a tedious process because businesses receive thousands of payments. Consider using automated cash application software to simplify the process.

Collections 

If you don’t receive and apply payment by the agreed-upon date, the customer’s account becomes delinquent.

You can transfer it to collections, where a collector will try to connect with the customer and work with them to collect the payment.

Benefits of accounts receivable

The nature of receivables is that they are both current and liquid assets. Their status as a current asset means that the customer must make payment of the due amount in a year or less. 

As a liquid asset, receivables are accessible to you. They form a part of your business’s more accessible capital, which you can use as a source of day-to-day funds.

Your company can use accounts receivable as collateral for loan applications and to fulfill short-term money obligations.

With both these characteristics of receivables, their accessibility and fast return, they become a vital source of working capital for your company to use daily.

Disadvantages of accounts receivable

The major disadvantage of receivables is that there’s no assurance that the customer will pay the amount due.

Of course, there is a legal obligation, particularly when you have documented evidence like an invoice or signed agreement. However, the customer may still avoid paying what’s due.

Sometimes, especially with smaller amounts, you may have to write the amount off as a loss or bad debt expense. This is because the cost of pursuing the case legally or otherwise (using your resources) may far surpass the returns of doing so.

What if customers don’t pay?

If customers fail to pay the amounts they owe you on time, take any of the following measures:

Cut late-paying customers off

If you have recurring customers that don’t fulfill their debts, consider reviewing their credit relationship with your business.  You can send them warnings initially and cut off their credit after recurring failures to pay on time.

Only keep offering credit to customers who meet their payments on time.

Convert their account receivable into a long-term note

Converting customers’ accounts receivable into notes receivable gives them more time to repay their debt. It’s the best move if you don’t want to write off the unpaid amount and count it as a bad debt.

As a notes receivable, the amount due counts as a current or non-current asset in your accounting books.

Hire a collection agency

You may also hire a collection agency to follow up with the customer on your behalf and get them to pay.

How to optimize your accounts receivable process

Here are some of our expert tips to help you manage your AR process more efficiently for an increased turnover ratio:

Develop a crystal-clear credit policy

Your customers must know what they agree to when they take on credit from your company. You must also have evidence of their commitment to your terms. Establishing straightforward and written credit policies and agreements will help you when you have to hold debtors accountable.

Also, use your credit policy as an opportunity to outline your ideal debtor’s qualifications and requirements, only accepting applicants who meet this profile and can fulfill payments.

Give customers more ways to pay

Giving customers various payment alternatives may reduce the need to collect receivables later. In addition to cash in person and EFTs, you can utilize dedicated financial services for international payments. Aim to make payment easy instantly but also for those paying their debt.

Call them and schedule regular reminders

It’s essential to follow up on missing balances. Prompting customers to make payments may remind those that have genuinely forgotten. It also ensures you don’t overlook payments too and lose money unnecessarily.

Automate your process

You can automate various steps in your account receivables process. For example, you can automate the invoicing using automated templates like free invoice builders and setting recurring invoices for installments or subscriptions. With good software, you can also automate payment reminders for your customers.

Payoneer enables you to integrate QuickBooks with its global payment solution. This allows you to automate your invoice reconciliation, matching your invoices to your income. You can also reconcile accounts receivable and payable to help you gauge your profits more accurately.

Conclusion

Managing a business requires a steady balance between flexibility and regulation. Of course, developing a relationship with customers is vital, and selling to them on credit can nurture trust between your business and them. However, this process requires clear policies and regulations and a well-controlled system.

If you are a small business owner or freelancer, you need to understand and optimize your accounts receivable processes so you can improve your cash management.

Oversee your accounts receivables efficiently with the information above and by following the ‘how-to’ tips we’ve provided. 

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