What are Accounts Receivable in Business?
Accounts receivable (AR) refer to the money owed to a business by its customers for goods or services delivered but not yet paid for. These amounts are recorded as your current assets on the balance sheet because they are expected to be converted into cash within a year.
Accounts receivable are crucial for maintaining cash flow and ensuring the financial health of your business.
Importance of Accounts Receivable in Business
Accounts receivable are essential for managing your cash flow and liquidity. They represent money that is expected to be received soon, which can be used to cover short-term obligations and operational costs.
Efficient management of accounts receivable ensures timely payment, reduces the risk of bad debts, and improves your overall financial stability.
What is the Accounts Receivable Process?
Here is how the accounts receivable process works:
Issuing Invoices
After goods or services are delivered, an invoice is issued to the customer detailing the amount owed, payment terms, and due date. This step initiates the accounts receivable process and sets the expectation for payment.
Recording Accounts Receivable
The invoiced amount is recorded in the accounting system as accounts receivable. This entry ensures that the business keeps track of all money owed by customers and can monitor outstanding payments.
Monitoring Outstanding Invoices
Regularly tracking unpaid invoices is essential to ensure they are paid within the agreed terms. This involves keeping an eye on due dates and identifying any overdue amounts that need follow-up.
Following Up on Late Payments
Sending reminders or contacting customers directly to encourage timely payment is a crucial step. Effective follow-up can help reduce the number of overdue invoices and improve cash flow.
Collection
Receiving the payment and updating the accounts to reflect the payment received completes the accounts receivable process. Timely collection ensures that your business has the necessary funds to meet financial obligations.
Accounts Receivable Turnover Ratio
The accounts receivable turnover ratio measures how efficiently a business collects payments from its customers. It is calculated by dividing net credit sales by the average accounts receivable. The formula is:
Accounts Receivable Turnover Ratio=Net Credit Sales/Average Accounts Receivable
Example of Calculating Accounts Receivable Turnover Ratio
If a company has net credit sales of $500,000 and the average accounts receivable balance is $50,000, the accounts receivable turnover ratio would be:
Accounts Receivable Turnover Ratio=500,000/50,000=10
This means the company collects its average accounts receivable 10 times a year, indicating efficient credit and collections processes.
How to Calculate the Average Accounts Receivable
To calculate the average accounts receivable, add the beginning and ending accounts receivable balances for a given period and divide by two. The formula is:
Average Accounts Receivable=(Beginning AR Balance+Ending AR Balance)/2
Example of Calculating Average Accounts Receivable
If the beginning accounts receivable balance is $40,000 and the ending balance is $60,000, the average accounts receivable is:
Average Accounts Receivable=40,000+60,0002=50,000
Accounts Receivable vs. Accounts Payable
Accounts receivable represent money owed to the business by customers for goods or services delivered on credit. It is recorded as a current asset on the balance sheet. Effective management of accounts receivable is crucial for maintaining positive cash flow.
Accounts payable represent money the business owes to suppliers for goods or services purchased on credit. It is recorded as a current liability on the balance sheet. Efficient management of accounts payable ensures that the business can meet its short-term obligations without straining cash reserves.
Accounts Receivable Financing
Accounts receivable financing is a method where businesses use their accounts receivable as collateral to secure a loan or sell their receivables to a third party at a discount for immediate cash. This can improve cash flow and provide working capital without waiting for customers to pay their invoices.
Managing Accounts Receivable
Here is how to effectively manage accounts receivable:
Setting Clear Payment Terms
Establishing and communicating clear payment terms to customers is essential to ensure timely payments. This includes specifying due dates, acceptable payment methods, and any penalties for late payments.
Regular Follow-Ups
Consistently following up on outstanding invoices encourages prompt payment. Automated reminders and periodic checks can help maintain a steady cash flow and reduce the risk of overdue payments.
Offering Early Payment Discounts
Incentivising customers to pay early by offering discounts can improve cash flow. For example, offering a small discount for payments made within 10 days can encourage faster payment and reduce the accounts receivable balance.
Using Accounting Software
Implementing accounting software to automate invoicing and tracking payments enhances efficiency and accuracy. Software tools can provide real-time insights into outstanding invoices and streamline the accounts receivable process.
FAQs About Accounts Receivable
What is a Good Accounts Receivable Turnover Ratio?
A good accounts receivable turnover ratio varies by industry, but generally, a higher ratio indicates you have an efficient collection process. A lower ratio may suggest issues with collecting payments.
How Can I Improve My Accounts Receivable Turnover Ratio?
Improve your accounts receivable turnover ratio by setting clear payment terms, following up on overdue invoices promptly, and offering incentives for early payments.
What Happens if Accounts Receivable are Not Collected?
Uncollected accounts receivable can lead to cash flow problems and may result in bad debts, negatively impacting the business’s financial health.
Need Help with Managing Accounts Receivable?
At First Class Accounts, we offer bookkeeping services to help you manage your accounts receivable efficiently.
Our experienced, nationally accredited bookkeepers can assist with invoicing, tracking payments, and improving your cash flow. Contact us today to learn more about how we can support your financial needs, or get started right away and find a local bookkeeper over here.