What is Accounts Receivable and Why Does it Matter for Your Business?

The competitiveness in the business world has increased during the last few years. Consequently, businesses are providing credit as a payment option more and more. Sales will undoubtedly rise as a result, but there is also a chance that payments get delayed.

Now, this is where the concept of accounts receivable (AR) comes in. In accounting, accounts receivable refers to any money consumers owe you for goods or services that were acquired on credit.

Managing accounts receivable is the best way to keep your cash flowing and manage your financial stability effectively. This article will dive deep into the meaning, benefits and risks associated with ACCOUNTS RECEIVABLE.

What Does "Accounts Receivable" (AR) Mean?

Accounts receivable (AR) are payments owed to a firm by customers or clients for goods or services provided, but the payment has not been made yet. It represents client credit and is recognised as an asset on the balance sheet.

When a firm offers its products or services on credit, it establishes an account of accounts receivable. Now, the company becomes responsible for collecting outstanding payments within a set time frame.

It usually contains the customer's name, invoice date, due date, the amount owed, and payment terms. Efficient AR management is essential for maintaining a healthy cash flow and minimising bad debts for your business.

How Does the Accounts Receivable Process Work?

Accounts receivables are recorded (and collected) using a simple process:

• A customer requests to buy products or services through a signed contract or purchase order.
• Goods and services are delivered.
• The merchant sends an invoice to the customer and credits accounts receivable with the amount owed to them.
• The consumer pays the balance; the merchant deducts it from accounts receivable and records it as a deposit.

Here is a flow chart to make this process simple for you:

What are the Benefits of Managing Accounts Receivable Effectively?

Managing Accounts Receivable Effectively Comes with Several Advantages

• Get Paid Faster -

Receiving payment sooner is one of the primary benefits of receivable management. Invoicing is one of the most crucial aspects of collecting payments from clients or vendors.

If the invoice is wrongly prepared, it will be returned for correction, perhaps further delaying payments. So, produce appropriate invoices to secure proper payment.

• Minimise Bad Debt Risk

Bad debts are a source of concern for all businesses because they impact the organisation's finances. When accounts receivable are not managed properly, it puts undue strain on the company's finances, resulting in bad debts.

A properly managed accounts receivable can considerably reduce bad debt problems, and your payments will always be clear.

• Accurate Credit Decisions

Receivables management enables businesses to follow clients with excellent payment histories. This allows the organisation to classify customers based on their payment history. It makes it easier for businesses to decide whether or not to offer client credit.

• Keep Track of Unreceived Payments

The most important aspect of receivable management is tracking unreceived payments. Managing receivables allows businesses and merchants to chase outstanding payments, facilitating the collection process.

• Efficient cash flow

Every company desires efficient cash flow to dedicate suitable resources to future initiatives. It can also help you use your money best during difficult times. A well-managed cash flow can be quite valuable in evaluating a corporation's ability to improve its performance.

Risk Associated with Accounts Receivable Process

There are some risks associated with the accounts receivable management process, which are as follows:

• Delayed or uncollected receivables might result in insufficient cash flow, making it challenging to pay financial obligations.
• A company with large accounts receivable balances may need external funding, increasing interest expenditures.
• Uncollected receivables, or dubious accounts, may eventually become uncollectible, resulting in the organisation's revenue loss.
• Unmonitored credit sales can result in excessive risk exposure, increasing the possibility of nonpayment.

These are some of the risks associated with the accounts receivable management process.

Accounts Receivable Turnover Ratio

The accounts receivable turnover ratio is a financial metric used to assess a company's performance in managing its accounts receivable. A greater ratio indicates more frequent receivable collection, whilst a lower percentage shows inefficient credit sales administration.

Formula to Calculate Accounts Receivable

The accounts receivable turnover ratio equals net credit sales and is divided by average accounts receivable.

Accounts Receivable Turnover Ratio = Net Credit Sales/ Average Accounts Receivable

Net credit sales are total sales on credit minus returns and allowances.

Average Accounts Receivable = the average of the accounts receivable balances at the start and end of the period.

Suppose your business sells $200,000 on credit per quarter and has an average annual accounts receivable of $20,000. Then, your accounts receivable turnover ratio would be 10.

What Are the Effective Ways to Manage Accounts Receivable?

Managing accounts receivable effectively

1. Create a Transparent Credit Policy

Establish terms for credit extension to clients, such as credit limitations, late payment fines, and payment terms.

2. Check Credit:

Examine consumer credit reports regularly to reduce the possibility of nonpayment.

3. Timely Invoice

To guarantee prompt payment, send bills as soon as products or services are delivered. Sending timely invoices helps get payments faster, and you don't have to run for late payments.

4. Put a Follow-up Procedure

Create a procedure that includes calls to collect past-due invoices, reminders, and escalation processes.

5. Early Bird Payment Rewards:

Provide rewards for making early payments and offer discounts or other rewards to consumers who pay on time to encourage early payment.

6. Keep An Eye on Accounts Receivable Turnover

Examine this data frequently to spot patterns and gauge how well your credit rules work.

7. Up to Date Credit Policy

Review your credit policies regularly to ensure they are still appropriate and make any necessary adjustments in light of shifting consumer trends and market circumstances.

The Bottom Line

Accounts receivable is one of the most significant line items on a company's balance sheet. It is money that a business has earned from selling its products or services to clients but has not yet received payment for.

A company's accounts receivable balance should decrease as quickly as possible because this indicates prompt payment and allows it to allocate funds to other areas of its operations.

Making wise credit decisions, keeping a healthy cash flow, and reducing bad debts depend on effective accounts receivable administration. By implementing excellent processes and consistently monitoring receivables, organisations can enhance their financial performance and facilitate sustainable growth.