What Are Account Receivables?

One-liner

Accounts receivable (AR) refers to the money that a business is owed by its customers for goods or services that have been delivered but not yet paid for.

Details

AR is typically recorded as a current asset on a business's balance sheet. It represents the amount of money that the business expects to receive from its customers in the near future, usually within one year or less.

Managing accounts receivable involves several key activities:

1. Invoicing: This involves creating and sending invoices to customers to request payment for goods or services that have been delivered. Invoices should include detailed information about the products or services that were provided, the prices charged, and the terms of payment.

2. Credit management: This involves setting credit policies for customers, including credit limits and terms of payment. It also involves monitoring customer creditworthiness and taking steps to reduce the risk of nonpayment.

3. Collections: This involves following up with customers who have not paid their invoices on time to request payment. This may involve sending reminders, making phone calls, or using other means to encourage payment.

4. Reconciliation: This involves reconciling the accounts receivable balance on the business's books with the actual amount of money that has been received from customers. This helps ensure that the business's records are accurate and that all payments have been properly recorded.

Key definitions

1. Invoice: A document that is sent to a customer requesting payment for goods or services that have been delivered. An invoice typically includes the name and contact information of the business, the name and contact information of the customer, a detailed description of the goods or services that were provided, the prices charged, and the terms of payment.

2. Credit limit: The maximum amount of credit that a business is willing to extend to a customer. This is typically based on the customer's creditworthiness and the business's credit policies.

3. Credit terms: The terms under which a business extends credit to a customer, including the payment due date and any late payment fees.

4. Aging report: A report that lists all of a business's accounts receivable and the length of time that each invoice has been outstanding. This report is used to identify which invoices are past due and need to be followed up on for payment.

5. Days sales outstanding (DSO): A measure of how long it takes a business to collect payment from its customers. It is calculated by dividing the total accounts receivable balance by the average daily sales, and then multiplying by the number of days in a period. A lower DSO indicates that the business is able to collect payment from its customers more quickly.

6. Credit risk: The risk that a customer will not pay their invoices on time or at all. This risk can be managed by setting credit limits, monitoring creditworthiness, and taking steps to reduce the risk of nonpayment.

7. Bad debt: Accounts receivable that are not expected to be collected because the customer is unable or unwilling to pay. This is recorded as a loss on the business's income statement.

KPIs

1. Days Sales Outstanding (DSO): This is a measure of the average number of days it takes a business to collect payment from its customers. A lower DSO indicates that the business is able to collect payment from its customers more quickly.

2. Payment delinquency rate: This is the percentage of customers who are late in paying their invoices. A high payment delinquency rate indicates that the business is having trouble collecting payments from its customers.

3. Write-off rate: This is the percentage of accounts receivable that the business is unable to collect and has written off as a loss. A high write-off rate indicates that the business is having difficulty collecting payments from its customers.

4. Credit approval rate: This is the percentage of credit applications that are approved by the business. A high credit approval rate may indicate that the business is not being selective enough in granting credit, which could lead to higher levels of payment delinquency and write-offs.

5. Average collection period: This is the average number of days it takes the business to collect payment from its customers. A longer average collection period may indicate that the business is having difficulty collecting payments from its customers.

6. Percentage of Current Accounts Receivable:  The big problem with DSO is that it doesn’t consider receivables before they’re due. It’s only concerned with receivables that have already become a problem. So it can’t do anything to help your collections team work proactively. That’s where the percentage of current A/R comes in. The percentage of Current A/R helps you better understand the relative distribution of current and overdue receivables. Instead of just looking at the payments that are late, it helps teams to be more proactive about high-value receivables that are about to come due.

7. Accounts receivable turnover ratio: Your accounts receivable turnover ratio shows how quickly your AR department is collecting payments and turning that money into cash. You can calculate it by dividing net sales by average accounts receivable. The formula for calculating accounts receivable turnover ratio is:

ART = net credit sales ÷ average accounts receivable

10 best practices

1. Establish clear payment terms: It is important to clearly communicate payment terms to customers, including when payment is due and any late payment fees that may apply. This helps to prevent misunderstandings and encourages timely payment.

2. Use invoicing and payment software: Invoicing and payment software can help businesses automate their accounts receivable processes, including generating invoices, tracking payment status, and sending reminders to customers.

3. Monitor payment trends: Regularly reviewing payment trends can help businesses identify any problems with their accounts receivable processes and take corrective action.

4. Follow up on overdue payments: It is important to follow up with customers who are late in paying their invoices. This can be done through phone calls, email reminders, or other methods.

5. Consider offering incentives for timely payment: Some businesses offer discounts or other incentives to customers who pay their invoices on time. This can help encourage timely payment and improve cash flow.

6. Monitor credit risk: It is important to carefully assess the credit risk of potential customers before extending credit. This can help to reduce the risk of bad debt and improve cash flow.

7. Make Payments Easy for Customers: Most payment issues you’ll encounter are because clients have trouble receiving, viewing, or understanding your invoices, or because they don’t have access to a quick and convenient payment method.

8. Decentralise AR process: Rather than the accounts or finance team following up on receivables, it’s better if the sales representative follows up due to the relationship that they maintain with the clients.

10 mistakes to avoid

• Incorrectly listing information on an invoice: Let’s say you forget to include your overdue policy—which includes a late fee—on a large invoice. If the buyer then misses their payment date, you won’t be able to collect on a potentially sizeable late fee because it wasn’t communicated in the original invoice. Clearly listing late payment terms on your invoices is also a strong incentive on its own to get customers paying on time.

• Miscommunicating with accounts receivable team members - Multiple followups from different teams will have a bad experience on the customer. Thus, ensure to have proper coordination between the teams while following up.

• Not following up on overdue invoices - Another common symptom of an overburdened AR team is not following up on overdue payments. Your team might not have an easy way to track which payments are overdue, and even if they do, they might not have time to followup on late payments.

• Applying payments to wrong invoices - Misapplied payments are a common problem in AR, but one that could have severe consequences. Your collections team might follow up with the buyer who already paid, which could sully the positive relationship you had with that customer. Or, if the other buyer doesn’t actually pay their invoice, you could potentially overlook the non-payment.

• Managing collections manually - Whether you have a part time A/R clerk or a full-time credit collections manager, there is an overwhelming amount of work that must be done to collect payment on past-due invoices. And things are made even worse when you rely on manual paper-based processes and spreadsheets to manage customer communications and past-due accounts. This is a very major mistake and you will need to implement a tool to manage collections effectively.

Top Recommendations for Tools

• Razorpay (Ind)

• Growfin (US)

• Lockstep (US)

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