What is accounts receivable? | A comprehensive guide

You've diligently managed your business, provided excellent client services, met deadlines, and exceeded expectations. You should be showing financial progress, but there's a catch: accounts receivable.

Your clients have received your services or goods on credit, and now they owe your business money. The outstanding payments are known as accounts receivable, and they can become a bottleneck for your business growth if they are not managed effectively.

Some businesses struggle to efficiently manage accounts receivable, but you can take steps to streamline your cash flow. This guide will help navigate the nuances of accounts receivable, from understanding its role in your business finances to adopting best practices for managing it effectively.

Accounts receivable 101

Let’s begin with a basic breakdown of what accounts receivable refers to and why it's a vital element of your business's financial ecosystem. 

What is accounts receivable?

You may have heard of accounts payable vs. accounts receivable and wondered what the difference is. Accounts payable are the debts your company owes. Accounts receivable, in its simplest terms, is the money your customers owe to your business.

When you provide goods or services on credit to your customers, you do so with the expectation that they’ll pay you back within a specific period. In a sense, you extend them a short-term, interest-free loan. These transactions’ values are recorded as accounts receivable in your books, where they’ll remain until your customers pay the invoices to which they’re linked.

These outstanding invoices represent more than just entries on your balance sheet—they are legal obligations for your customers. According to the agreed payment terms, your customers typically have 30 to 90 days (depending on industry norms) to make the payment. This brings cash into your business, and once the transactions are recorded, the accounts receivable are marked as paid. In simpler terms, you complete the receivable cycle, and the invoices shift from being legal IOUs to documented, finalized cash payments.

Why accounts receivable is crucial for businesses

When your customers pay their invoices on time according to your credit terms, it turns your earned revenue into accessible cash. This cash inflow is essential for your day-to-day operations, including supplier payments, operational costs, and business reinvestments and expansions.

A streamlined accounts receivable process can do more than impact your cash flow. Your business can also grow rapidly with efficient processes. This is why your business needs a process in place to recognize unpaid invoices and ensure prompt payment. 

With proper systems in place, you can ensure timely payments from your customers. This optimizes your cash flow, improves relationships with your customer base, reduces the likelihood of bad debt, and contributes to a healthier financial outlook.

Components of accounts receivable

Each element of accounts receivable, such as invoicing and billing, credit terms, and the aging process of accounts receivable, plays an integral part in shaping your company's financial foundation. A better understanding of how these aspects work together gives you a better understanding of how accounts receivable affect your cash flow and overall financial health.

Invoicing and billing

An invoice acts as a legal document stating your customer's obligation to pay you for the services or goods received. The accrual accounting process creates these invoices as a way for your company to record revenue before receiving payment. Once you've delivered goods or services to your customers, your business generates an invoice that details the goods or services provided, their individual cost, the total amount due, taxes, and the agreed-upon payment terms.

Accurate invoicing and billing ensure clarity. Accounting software can automate the invoicing process, lead to greater precision, save time, and minimize the risk of human error. Speed and accuracy in billing instill confidence in the customer and recover payments promptly, which sustains a healthy influx of cash into your business.

Credit terms

Credit terms are the conditions you set regarding when and how your customers are expected to clear their debts for any goods or services you delivered on credit. The terms should clearly mention the expected timeframe for payment, typically expressed as "Net 30" or "Net 60", indicating 30 or 60 days, respectively, to fulfill the payment. These terms may also include the methods of payment your business accepts.

There is a balance of fair and clear credit terms to cater to your business's cash flow needs and respect your customers' payment capabilities. The terms under which you grant credit to customers need to be short enough to ensure a consistent cash inflow but flexible enough to attract and retain customers.

Consistently clear and favorable credit terms create a healthy business relationship, leading to prompt customer payments. It’s good practice to periodically review your credit terms to ensure they align with your business goals and changing market conditions.

Aging of accounts receivable

Tracking the aging of accounts receivable is a way to organize and handle invoices by considering how long they've been unpaid. You can categorize invoices into categories or accounting periods like 30, 60, or 90 days to get a better picture of which invoices are outstanding and which are overdue.

When you monitor invoice aging, you can prioritize your collection efforts. If invoices age indefinitely, it can negatively impact your cash flow and profit. Uncollected invoices lead to bad debt expenses. 

Keep a sharp eye on your accounts receivable aging to spot any red flags early and correct them. This creates an efficient, proactive approach to your collection process and improves your overall accounts receivable turnover ratio.

How to manage accounts receivable

Whether you're a small business juggling a handful of clients or a large corporation dealing with an overflow of unpaid bills, effective accounts receivable management is key. The following insights and strategies can help you streamline your process, boost efficiency, and maintain strong client relationships, resulting in smoother cash flows for your business.

Establish clear credit policies

One key aspect to effectively manage your accounts receivable is to establish clear credit policies. This provides a blueprint for managing customer credit and outlines the criteria for extending credit to customers. Your credit policy should clearly detail the credit terms, early payment incentives, and repercussions for late payments.

Your business benefits in multiple ways when you set distinct terms and conditions for your customers. It lays out what's expected in terms of payment for your customers and gives your accounting department firm guidelines to follow. It can also lay out any terms if you allow customers to pay over time or if you accept invoices to be paid in multiple transactions over a set period. A clear credit policy can help avoid misunderstandings, reduce payment disputes, and ensure that your cash flow remains healthy.

Invoice promptly and accurately

As soon as your business provides a good or service, an invoice should follow. Quick invoicing gives the customer ample time to make payment within the agreed-upon period and can shorten the payment cycle, which improves your cash flow.

Accuracy is equally important, as errors can delay payments and damage your business relationships. An invoice should clearly state the details of the transaction, including a description of the goods or services, quantity, price, date, invoice number, and payment terms. Accurate, detailed invoicing reduces the chance of disputes. The use of accounting software can eliminate errors, ensure uniformity, and expedite the invoicing process.

Offer early payment discounts

Offer early payment discounts to incentivize your customers to pay their invoices before the due date. For instance, a “2/10 net 30” offer gives the customer a 2% discount if they pay within 10 days rather than waiting for the full 30. This encourages prompt payments from customers and often reduces the time between the sale of a product or service and when the payment is received.

While it may seem like you're eating into your profit margin a little, the benefits of improved cash flow and reduced time spent chasing payments outweigh this small cost.

Follow up on overdue accounts promptly and persistently

It's essential to remind your customers of their overdue obligations. If an account becomes overdue, you should contact your customer as soon as possible. Timely and consistent follow-up reinforces your payment deadlines and will encourage customers to prioritize paying your business on time. These “friendly reminder” contacts help nudge slow-paying customers and reduce the risk of bad debt.

It's a good idea for a business to automate the follow-up process using accounting software that can send reminder emails or notifications at predetermined dates. You might also offer various payment methods to make the process easier for your customers.

Consider using a collection agency for difficult accounts

If your internal efforts to recover past-due accounts don’t work out or if the time-consuming collections process is draining your resources, you may wish to consider turning to a collection agency. These agencies specialize in recovering overdue payments and can help you deal with difficult accounts. Collection agencies have the experience, resources, and legal knowledge to effectively pursue payment without crossing legal boundaries.

While this service comes with a cost (typically a percentage of the amount collected), it can be a good option for accounts that have been delinquent for some time. Your business can then focus on its core operations while the agency improves your accounts receivable turnover ratio.

It’s important to weigh factors like the agency's fee, the age and value of the unpaid invoices, the relationship with your client, and the potential impact on your business reputation before using a collection agency.

Train your staff on best practices for managing accounts receivable

Effective management of accounts receivable isn't a one-person show. It calls for a competent and knowledgeable team. Invest resources to educate your staff about account receivables best practices and significantly streamline your receivable process. Training should involve a thorough understanding of credit terms, efficient billing and invoicing, assertive follow-up techniques, and when and how to escalate overdue accounts.

The financial impact of accounts receivable

Outstanding invoices affect your cash flow and shape your business's financial stability and growth potential. Understanding these effects can help you make more informed financial decisions and place the appropriate emphasis on accounts receivable policies for your business.

Cash flow management

Cash flow and accounts receivable are intrinsically linked. Your cash flow is the livelihood of your business. When your customers make their payments on time, you maintain a steady cash inflow that can be used to cover your operational expenses, reinvest in your business growth, or manage your debts more efficiently.

Your accounts receivable management directly affects your cash flow. It is a critical part of your cash conversion cycle, or the time it takes for your company to convert resources like inventory or labor into cash flows from sales.

A shorter cash conversion cycle indicates a more efficient use of resources. Discrepancies or late or missing customer payments in accounts receivable can tie up your cash and hinder your business operation and growth. This can impact your ability to manage your own accounts payable for services or goods you need to run your day-to-day operations. Adopt efficient accounts payable vs. accounts receivable management strategies to sustain a healthy cash flow for your business and keep operations smooth sailing.

Impact on financial statements

Accounts receivable plays a significant role in your financial statements and directly impacts your business's profitability and liquidity visuals. Your balance sheet represents accounts receivable as a current asset, which shows the amount your customers owe you for goods or services delivered on credit. This forms part of your business's total assets and contributes to the overall balance of accounts.

However, there's a flip side. If an account is not collected and goes into bad debt, it changes from an asset to an expense. Bad debts are recorded on your income statement and reduce your company's overall revenue and performance metrics. A significant amount of bad debt can hurt your company's profitability and negatively impact your financial picture.

The role of technology in accounts receivable

Your business can automate many time-consuming, labor-intensive tasks with the right accounting software. This technology creates and sends invoices, sends follow-up reminders for overdue payments, and records payments as they’re received. Accounting software not only saves time and increases efficiency but also dramatically reduces the chances of human error.

Many software applications offer robust reporting capabilities that provide valuable insights into your accounts receivable process. This includes detailed reports on outstanding invoices, customer payment habits, and your accounts receivable turnover ratio. These real-time insights let you identify areas where your business can improve, inform your decisions, streamline your processes, and ultimately enhance your cash inflow and outflow.

Legal and ethical aspects of accounts receivable

In managing your accounts receivable, it's important to be aware of and comply with both legal and ethical practices. Just as overdue payments are a part of business reality, so is the collection process. However, this process needs to be handled respectfully and professionally. It's vital to uphold ethical standards, pursue transparency, and maintain respectful communication with your customers at all times.

From a legal perspective, your company must obey all federal, state, and local debt collection laws. This could include provisions about when and how often you can contact a debtor, what you can say, and the actions you can take to collect on a debt. It's crucial to follow laws to avoid significant fines and other penalties for your company.

Understanding these laws and ensuring your business practices and internal controls align contribute to a positive business image and maintain customer relationships.

Future trends in accounts receivable

Technology will continue to be a critical player in managing accounts receivable. Technological tools like automated billing systems and generative AI can help businesses streamline their accounts receivable process, save time, and minimize the impact of human error.

There may also be an uptick in the adoption of accounts receivable financing, which lets businesses sell their unpaid invoices to lenders for quick cash. This converts the cost of pursuing unpaid invoices into another way your business can secure financing to overcome short-term cash flow issues.

Stay ahead of the financial curve

While all parts of your business finances are important, accounts receivable management empowers you to take charge of your cash flow, boost efficiency, cultivate strong client relationships, and, above all, stay a step ahead of your expenses.

Balancing these elements correctly gives you the footing to navigate fluctuations and unexpected hitches in your financial landscape. Evaluate any current gaps in your current accounts receivable processes, and look for places where technology or new systems can help you streamline steps. Ensure you have the tools to successfully manage your accounts receivable to secure continued success and a brighter financial future for your business.

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