What is accounts receivable (and how to manage it)
Managing your accounts receivable is an integral part of running your own business. That said, many businesses who sell products and services to clients on credit sales often find their cash flow disrupted because of late payments.
To improve the cash flow and overall success of your business, it’s important to minimise the time it takes for your business to receive a payment. This is exactly what accounts receivable management is all about.
In this article, we’ll explain what accounts receivable is, why it matters and how you can effectively manage it to boost the financial health of your business.
Table of contents
- What is accounts receivable?
- How does accounts receivable work?
- A note on accounts receivable turnover ratio
- An example of accounts receivable
- Why your business needs to manage accounts receivable
- How to manage your accounts receivable
- Wrapping Up
What is accounts receivable?
Accounts receivable is the total amount of money that customers owe your business in exchange for products or services they’ve already received.
This means that even though you have technically made a sale, and goods have been delivered or the execution of services has begun or been fulfilled, you haven’t yet received any money for it.
This amount due is recorded in the company’s financial statements as accounts receivable.
Accounts receivable is considered an asset, as the money is expected to be collected at a future date. These terms are usually extended from a few days to several weeks, or even a calendar month or fiscal year.
In layman’s terms, accounts receivable is considered an “IOU”.
How does accounts receivable work?
On the balance sheet, your accounts receivable will be classed as a “current asset”, as there is a legal obligation for clients to pay what they owe. Because it’s a current asset, it means that the account must be owed or paid within a year (or less).
Here are some cases where accounts receivable may apply to your business:
- When several sales have been made, and it’s easier for a customer to settle debts in one single transaction rather than multiple actions
- Where businesses agree to send an invoice after a service has been delivered
- Where goods are not of a physical nature, for example, a water bill is sent after a period where the meter has been read
- When an opportunity arises that can propel a business to a new level of growth
Many companies operate by allowing a number of sales to be classified as accounts receivable. Some companies feel more comfortable offering this line of credit to frequent or reliable customers, as they trust that the amount will be paid in full when it’s due.
Others choose to add a layer of protection to their business dealings by including interest in their agreements, which is a legal option available to you thanks to the Late Payment of Commercial Debts (Interest) Act 1998.
In extreme circumstances, clients may end up disappearing completely. When this happens, the amount due becomes known as “bad debts.”
Bad debts, in accounting terms, is an expense that a business incurs once the repayment of credit is considered to be uncollectible. We’ll explain exactly how to handle bad debts in a later section.
A note on accounts receivable turnover ratio
Another important aspect of understanding accounts receivable is the concept of accounts receivable turnover ratio. This is a method of analysing how effective your business is at recovering funds and credit owed to you.
Accounts receivable turnover ratio is calculated using the following formula:
- Take the total accounts receivable from the beginning and end of an accounting period and divide them by two.
- Divide the number of net credit sales (total sales value you generated during that period) by the average accounts receivable value.
As an example, Business A is now into Q2 and wants to know how often it settled up its accounts receivable in Q1.
Its total accounts receivable for the beginning and end of Q1 were £20,000 and £15,000, respectively.
Its gross sales for Q1 were £50,000 and it had £10,000 in returns.
To figure out its accounts receivable, Business A would simply plug those numbers into the formula:
Q1 Accounts Receivable Turnover Ratio = £50,000 – £10,000 / (£20,000 + £15,000) / 2
Q1 Accounts Receivable = £40,000 / £17,500 = 2.3
Business A collected its accounts receivable 2.3 times in Q1.
And voila, you have your accounts receivable turnover ratio.
An example of accounts receivable
Our fictional customer, Jessica, wants to purchase a large order of baked goods for an event she’s running. The total amount for all goods comes to £2,000. However, Jessica won’t have the funds to pay the total amount until 30 days after the event has taken place.
Instead of refusing Jessica’s business, Wilson Bakery (Jessica’s favourite) agrees to payment terms of NET 45 (i.e. the invoice must be paid 45 days after it’s received). Wilson Bakery can make this decision at their own discretion, which may take into account factors such as the risk/reward ratio for such a large order, as well as the credibility of the company Jessica works for.
Once the credit has been paid, Wilson Bakery will attribute that amount to sales received or cash flow.
But, what if Jessica doesn’t pay Wilson Bakery in time, or at all?
The money will still be owed by Jessica, but Wilson Bakery would be out of pocket. This includes any cost of sales, as well as employee labour. This is where sales and accounts receivable differ. Sales refers to cash received, whereas accounts receivable is cash owed by an individual or organisation.
From here, Wilson Bakery can go through the usual process of chasing up an overdue invoice, which includes a follow-up sequence and, if necessary, referring the issue to a collections agency.
Why your business needs to manage accounts receivable
Done right, effective accounts receivable management can significantly strengthen your company’s financial position.
Why? Because accounts receivable are key for not only analysing your accounts, but also the amount of liquid assets that you own. It also allows you to estimate if you can pay short-term debts without the concerns of short-term cash flow shortage.
But handing out a line of credit to a customer in the form of an IOU is always a risk. Indeed, if a customer owes you thousands of pounds in overdue invoices, your cash flow could take a big hit and force productivity to a standstill.
However, there is an upside in terms of creating “working capital” on your books. It can also help you capture and retain more customers, as providing flexible payment options is more likely to generate sales.
Here are four reasons your business should prioritise managing its accounts receivable.
1. It gives you better control over your cash
One of the key reasons you should manage your accounts receivable is because it helps you have increased control over your business’s cash flow.
The faster the money that’s owed to you enters your bank account, the quicker you’ll be able to get your hands on it and use it to manage and scale your business
For example, you’ll be able to better cover recurring basic expenses, such as company overheads, salaries, and subscription charges.
A healthy cash flow will also put you in a favourable position to make more accurate financial projections for your business.
Having cash in hand also empowers small business owners to make profitable business decisions, such as purchasing important assets that contribute to the company’s growth, or investing in diversification and acquisitions.
2. Improve supplier relationships
Getting paid on time can help you build stronger relationships with existing suppliers, as well as land better deals with new ones.
Consider, for example, that you owe money to a supplier but are unable to pay them because a customer didn’t pay you on time. A situation like this can potentially damage your reputation and diminish trust.
If you regularly make your payments on time, however, you’ll be able to improve your credibility and reliability and suppliers will be excited to work with you.
3. Land better investment opportunities
Good accounts receivable management can help you show strong financial figures for your company, which is a great way to get potential investors on board and secure funding.
Accounts receivable is listed on your company’s balance sheet as a current asset. When investors look at your financial statements, they’ll be able to see how much cash you actually have on hand and how much of it is tied up in accounts receivable.
In some cases, a high accounts receivable balance could indicate a poorly developed business model, which can be a red flag for potential investors.
A low accounts receivable balance, on the other hand, could indicate healthier cash flow and a strong business model, which puts you in a favourable position in front of investors.
4. Save money
Last but not least, excellent accounts receivable management helps you save tons of cash.
When you have a proper system in place for managing your accounts receivable, you’ll be able to reduce the need to run after clients for payments.
The amount of money saved can instead be invested in more important things, such as improving your business processes, enhancing your marketing efforts, introducing new products or services, building out your team, and much more.
How to manage your accounts receivable
Now that you know about the benefits of managing accounts receivable, here are 7 ways to effectively manage it for your own business.
1. Evaluate clients’ financial and credit history
The best way to manage your accounts receivable is to get into business with clients who have a good reputation in the first place.
Before you close a deal or sign any contract, make sure you vet your potential client and their business.
Find out what other businesses in the industry have to say about them, and inquire about their financial and credit history. You can read public reviews and testimonials online or even reach out to their existing customers to see if they’d be willing to talk to you about their business relationship.
Private businesses won’t disclose financial details online, but you can search for basic information about them on GOV.UK’s website. Publicly traded companies do disclose their business financials to the public, which you can find with an online search.
More often than not, history tends to repeat itself when it comes to bad debtors. The last thing you want to do is conduct business with someone you should have known would have you running after them for each payment.
Not only can this get extremely frustrating, but it can also eat up tons of your valuable time and money, which is counter-productive for the growth of your business.
2. Decide on payment terms in advance
Another way to prevent late payments from clients is to decide on the payment terms before getting into any sort of agreement.
Payment terms can vary with the nature of your business, industry, and even the type of product or service that you’re selling.
Below are two payment terms you should consider discussing with your clients in advance:
- When the payment is due
- What payment methods they can use
Ideally, you should offer multiple payment options to your clients to make it easier for them to pay you on time.
For example, instead of sticking to just cash payments, consider offering options like a credit card, PayPal, and bank transfer.
Deciding on payment terms in advance reduces ambiguity, sets expectations, and gives more confidence to both parties in the binding contract.
3. Set up an invoicing system
Having an organised invoicing system in place for your small business can help you send accurate invoices on time.
If you send prompt invoices, you’ll be more likely to receive your payments on or before the due dates.
Manual invoicing can be extremely time-consuming. You would need to fill in each and every invoice by hand, sign and stamp it before sending it to the client and then wait for delivery and confirmation, sending manual reminders along the way.
To make invoicing easier, consider investing in software that helps you easily create and send invoices to your clients. Some tools even allow you to automate reminders for payments past due, saving you time and worry.
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4. Confirm receipt of invoices
A tried-and-tested method of getting paid on time is to ask your clients to confirm that they have received your invoice.
You could assign this task to your accountant, who can reach out to either the actual client or their accountant.
Confirming the receipt of your outstanding invoices is a simple, yet effective way to keep customers on their toes. It’s a subtle reminder for them to make their payment on time, and also prevents them from making any excuses about not receiving the invoice in the first place.
5. Plan ahead for bad debts
Good accounts receivable management involves monitoring and flagging risky accounts, and planning ahead for how to deal with them if they refuse to pay.
In some cases, you might need to resort to factoring such accounts.
In accounting terms, factoring is a financial transaction that involves selling off accounts receivable, or invoices, to a third-party at a discounted rate.
This helps you get your hands on immediate cash, even if it’s less than the original amount quoted, and takes the burden of running after clients off your shoulders.
It’s important to note that there are two types of factoring: recourse factoring and non-recourse factoring.
With recourse factoring, even if you sell your outstanding invoices to a third party, you are still liable for this debt and must pay it in full back to the factor if your client has not paid their invoice after a period of time.
With non-recourse factoring, you sell both the invoices and the liability to a third party, relieving you of any responsibility if your client never pays the invoice. Because this is a high risk exchange, non-recourse factoring is often limited to large corporations with a proven track record of clients eventually paying their invoices.
Treat factoring as a short-term fix that should only be considered as a last resort. Before you sell off your accounts receivable, make sure you’ve followed up with these clients multiple times.
6. Incentivise customers to pay you on time
To encourage customers to pay you on time, you might want to offer certain incentives on early payments, or even penalties or late fees on overdue payments.
This is effective because customers are more likely to pay in advance if they feel they’re getting an even better deal that way.
For example, if your product costs £4,500, you could offer a 5% discount on the total price if the customer makes the payment on or before a certain date.
Similarly, you could charge 5% extra on payments made after the due date mentioned on your invoice.
Another way to encourage customers to pay you on time is to offer them an option to pay their unpaid invoices in instalments. For example, for the product above, you could allow the client to make 20% of the payment each month for the next five months.
This might not be an ideal way to get paid, as it can still put a dent in your working capital. But the upside is that it can increase your chances of getting paid the full amount within a set period of time.
7. Make timely adjustments to your financial statements
Regardless of whether you’ve received your due payments or not, you’ll need to make some adjustments to your financial statements to draw an accurate picture of your business’s financial health.
For example, let’s say that a customer named John purchased items of around £30,000 from your business on a line of credit.
The initial entry you’ll make to record the transaction would be:
- Accounts receivable £30,000 – Debit
- Revenue £30,000 – Credit
Once John pays his dues, you’ll need to make an adjustment entry for the transaction:
- Cash £30,000 – Debit
- Accounts receivable £30,000 – Credit
The example above was pretty straightforward, but you may come across customers who aren’t able to pay you at all.
In that case, there are two methods you can use to adjust your account balances.
1. Direct write-off method
This method is used for customers/accounts that are deemed as non-collectible as per the business’s bad debt policy.
For adjustment purposes, the non-collectible amount is classified as an expense and the receivables are written off.
Going back to our example above, if John is unable to make his payment even after 5 months, you may consider his account non-collectible.
The adjusting entry you’ll make would look like this:
- Bad debt expense £30,000 – Debit
- Accounts receivable £30,000 – Credit
2. Allowance method
This method is used for customers/accounts that haven’t made payments yet, but may make payments at a later date.
For adjustment purposes, bad debts are expensed based on a percentage of sales or accounts receivable at the end of the financial period.
For example, consider that your company has a total of £200,000 as accounts receivable at the end of June 2020. You may decide that you’re not going to collect 4% of this amount.
This ‘allowance’ will be recorded as follows:
- Bad debt expense £8,000 – Debit
- Allowance for doubtful accounts £8,000 – Credit
With this method, any amount in the future considered as uncollectible will offset the allowance account with a debit and credit the accounts receivable balance.
Many business owners overlook the importance of properly managing their accounts receivable. If done right, however, it can boost the bottom line of your business, improve its cash flow, and help you secure better investment opportunities.
You can learn to effectively manage your accounts receivable by implementing solid internal processes, such as for invoicing and making adjustment entries, planning ahead for bad debts, monitoring risky accounts and discussing payment terms with clients in advance.
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