Understanding Accounts Receivable

Accounts receivable (AR) represents the money that customers owe to a business for products or services they have received but haven’t paid for yet. 

Managing AR well is important because it helps a business have enough cash on hand for its daily operations and growth.

This article will explain the basics and tips for good AR management. This guide is also related to our articles on understanding journal entries in accounting, cash vs. accrual accounting, and how to read a balance sheet.

This list includes:

• account receivable meaning
• account receivable debit or credit
• Accounts receivable vs accounts payable
• accounts receivable formula

Let’s start learning!

Basics of accounts receivable

Accounts Receivable (AR) is money that customers owe your business for goods or services they’ve received but haven’t paid for yet. When you sell something on credit, you create accounts receivable. This appears on your financial statements as an asset because it’s cash that you expect to collect.

Your cash flow benefits directly from collecting AR quickly. Cash increases your liquidity, which makes your business more flexible and resilient. If customers take too long to pay, your business might find itself strapped for cash, struggling to pay bills.

While AR refers to money others owe you, Accounts Payable (AP) is the opposite. AP is what you owe your suppliers or any third parties for goods or services your business has received but not yet paid for. 

Recording accounts receivable

There’s two steps to accounts receivable; creating the invoice and recording the payment.

Step 1: Create invoice

When a business delivers goods or services, it generates an invoice that details the amount owed by the customer. For example, if a business sells $1,000 worth of products to a customer on credit, the journal entry to record this transaction would be:

• Debit Accounts Receivable $1,000 (to record the amount the customer owes)
• Credit Sales Revenue $1,000 (to record the revenue earned from the sale)

This entry increases the business’s accounts receivable and its sales revenue, showing that the business expects to receive money and has earned it through sales.

Step 2: Receive payment

When the customer pays the invoice, the business needs to record the receipt of cash. For instance, if the customer pays the full $1,000, the journal entry would be:

• Debit Cash $1,000 (to record the increase in cash)
• Credit Accounts Receivable $1,000 (to indicate that the amount owed by the customer is now paid)

This entry moves the amount from accounts receivable to cash, reflecting that the business no longer expects this amount from the customer because it has been received.

AR Reports

An AR report provides a snapshot of all outstanding customer debts, categorized by the time elapsed since the invoice due date typically 30, 60, and 90 days. 

Net 30 is a common payment term that means the full payment is due within 30 days of the invoice date. Similarly, Net 60 and Net 90 terms extend this period to 60 and 90 days, respectively.

This categorization on the AR report helps you quickly see which invoices are approaching due dates and which are overdue.

Credit memos are issued to correct a previously issued invoice or to provide a customer with a refund or discount after an invoice has already been issued. For example, if a customer returns goods or if there was a pricing error, a credit memo reduces the amount that the customer owes. 

Make sure to keep your AR report and individual customer accounts under close review. Look out for receivables that are 30, 60, or even 90 days late. Act right away by sending reminders or making calls to encourage your customers to send payment.

Bad debt

Bad debt happens when you can’t collect payment from a customer after multiple attempts. This is money you expected but won’t receive.

When you determine an invoice is unlikely to be paid, you need to record this loss in your accounting books. Here’s how you do it with a simple journal entry:

• Debit Bad Debt Expense for the amount you cannot collect. This increases your expenses.
• Credit Accounts Receivable for the same amount. This decreases the money owed to you.

For example, if you decide that $500 from a customer is uncollectable, the journal entry would look like this:

• Debit Bad Debt Expense $500
• Credit Accounts Receivable $500

This entry shows that you recognize the loss of $500 as bad debt, which is now reflected as an expense in your financial statements. 

Regularly review your accounts receivable to identify any potential bad debts early. 

How to manage accounts receivable

Managing your accounts receivable is about speeding up the payment process so your business doesn’t run into cash flow problems. Here are some tools you can use to keep your AR in check.

Keep your invoices clear and accurate

First things first: make sure your invoices are easy to understand and error-free. This might seem basic, but it’s crucial. An invoice should clearly outline what the charges are for, including dates, quantities, and prices. 

If your customer has to guess or figure out details, it could delay payment. Always double-check the invoice details before sending them out.

Stay on top of billing

Timing is everything. Bill your customers as soon as possible after delivering a product or service. The sooner you invoice, the sooner you can expect to be paid. Also, don’t shy away from following up. If a payment is late, send a polite reminder. 

Sometimes, all it takes is a nudge for your invoice to be processed.

Make invoices easy to pay

The easier it is for your customers to pay, the faster you’ll get your money. Think about making ACH or credit card payment options available. You’ll have to pay some extra processing fees, but it might be worth it to get paid faster.

Use payment incentives

Who doesn’t love a good deal? Offering discounts for early payments can motivate your customers to settle their invoices ahead of time. Even a small percentage off can make a big difference in how quickly you get paid.

Be careful with credit

It’s essential to have clear credit management policies in place. Decide who you’re willing to extend credit to, under what terms, and how you’ll handle late payments. This might include performing credit checks on new clients or setting up specific payment terms that all clients need to follow. 

Use clear terms and conditions

Never underestimate the power of clearly stated terms and conditions on your invoices. These should cover payment terms (like net 30), late payment penalties, and any discounts for early payments. Having these terms laid out clearly can help prevent disputes and misunderstandings. Plus, if a payment issue ever escalates, you’ll have a solid basis for your actions.

Keep customer relationships strong

Never underestimate the power of a good relationship. Customers who feel valued are more likely to pay on time. Keep communication open, especially if they’re facing difficulties. 

A client may be facing temporary difficulties, and a little flexibility on your part can help maintain a strong business relationship while ensuring you’ll get paid. Sometimes, offering a payment plan is better than no payment at all.

Dealing with risks in accounts receivable

The two most common risks in AR management are delayed payments and bad debt (invoices you’ll never collect). Here’s some tools that can help you mitigate those risks.

Credit checks: Before extending credit to new customers, perform a credit check to assess their payment history and financial health.

Deposit or advance payment: For new customers or large orders, consider requiring a deposit or an advance payment to minimize the risk of non-payment.

Diversification: Diversify your customer base to avoid over-reliance on a few clients who, if they fail to pay, could significantly impact your business.

Legal considerations and remedies for non-payment

 If you’re faced with non-payment, it’s important to know your legal options and remedies. While legal action should be a last resort, here are some steps to consider:

• Payment reminders and negotiation: Start with friendly payment reminders and attempt to negotiate payment terms. Sometimes, a payment plan can be a practical solution for both parties.
• Letter of demand: If reminders fail, a formal letter of demand can be sent as a precursor to legal action, often prompting the debtor to settle the account.
• Debt collection agencies: For difficult cases, employing a debt collection agency can be an effective way to recover owed money. These agencies specialize in collecting debts, though they typically charge a fee or percentage of the collected amount.
• Legal action: As a final step, you may consider legal action against a non-paying customer. This can involve small claims court or hiring a lawyer to pursue the debt, depending on the amount owed and the specific circumstances.

By being proactive and vigilant in managing your accounts receivable, you can mitigate risks, ensure a healthier cash flow, and build a more resilient business.

Calculating Days Sales Outstanding

The most common metric businesses use to track the health of their AR is Days Sales Outstanding (DSO). 

Days Sales Outstanding (DSO) measures how long it takes, on average, to collect payments from customers after a sale is made. To calculate DSO, you divide the total amount of accounts receivable during a certain period by the total sales made on credit during that period, then multiply the result by the number of days in the period. This gives you the average number of days it takes to collect the payment. Lower DSO numbers mean you’re getting paid faster, which is good for your business’s cash flow.

Let’s say your business has $50,000 in accounts receivable at the end of a 30-day period and made $100,000 in credit sales during the same period. To find the Days Sales Outstanding (DSO), you would use the following formula:

DSO = (AR / Total Credit Sales) x Number of days in the period

Using the numbers from our example:

• AR (Accounts Receivable) = $50,000
• Total Credit Sales = $100,000
• Number of days in the period = 30 days

Plugging these values into the formula:

DSO = ($50,000 / $100,000) x 30 = 0.5 x 30 = 15 days

This shows that it takes 15 days on average to collect the receivables from sales. A DSO of 15 is quite efficient, indicating good credit control and quick payment from customers.

If your DSO is significantly higher than the industry average, it might be time to reevaluate your credit policies or collection practices. Industry associations, financial reports, and benchmarking services can provide these comparative data points.

Accounts receivable in different business models

Accounts Receivable (AR) practices can vary widely across different industries and between service and product-based businesses. Here’s some broad strokes of how various industries treat AR.

Service industries 

In service-oriented businesses, invoicing often occurs after the service is delivered, which can lead to a gap between service delivery and payment. 

Product-based industries 

Many business-to-consumer (B2C) product companies receive payments on the spot when the product is sold. However, wholesale or business-to-business (B2B) companies often sell products on credit.

Subscription models

Businesses with subscription models enjoy more predictable revenue streams. Many subscription services charge upfront for six months to a year of services, which is a very strong cash flow position to be in. However, subscription businesses have to manage customer churn and ensure easy payment processes to maintain steady cash flow.

Construction and project-based work

These industries often deal with milestone billing, where payments are tied to the completion of project stages. Detailed contracts and clear communication about payment expectations for each milestone are important.

Conclusion

Managing AR well means you get paid faster, improving your cash flow and, ultimately, your bottom line.

Pay close attention to your accounts receivable. It’s key for keeping cash flowing and your business thriving. Use smart strategies, embrace tech, and always look for ways to improve. Doing this not only secures your income but also strengthens your business’s financial health.

Next, check out our articles on how to hire a virtual bookkeeper, bookkeeping vs. accounting, and 15 accounting statistics and trends to know.

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