Monitoring your business assets is a vital but often daunting task for any business owner. And one asset that requires constant monitoring is your accounts receivables. For new business owners, this can often become overwhelming, particularly if you don’t have a strong accounting background.
Don’t panic though!
We’re going to take you through the foundation of the accounts receivable meaning, processes, why it’s important, and how you can manage it with one simple solution.
The receivables category in accounting is usually divided into three types:
1. Accounts receivable
This is your credit sales where customers buy goods and services on credit.
2. Notes receivable
This is a letter where a loan has accrued a bill of between two-to-three months. If this is not settled within a specified timeframe, the amount will be subject to interest.
3. Other receivables
This is a broader receivable that can be reported separately on a balance sheet. This includes:
For a more specific definition of accounts receivable, this is essentially the money that your company receives from a customer for purchasing a product or service on credit. Either they don’t have the funds currently, or they will pay you once they’ve sold the product to a third party. Depending on your company, the credit period can range anywhere from a few days through to two months, but either way, it is reflected as an asset on your balance sheet.
On the other side of the balance sheet is the accounts payable column. This is when you buy goods and services from a supplier on credit which you need to pay back within a limited period of time. This will be marked on your balance sheet under ‘current liabilities’.
Your liquidity analysis is where your accounts receivable and accounts payable are compared to ensure you have sufficient funds coming into your business so that you can pay off any debt. Your receivables are a current asset, while your payables are a current liability. This means that your receivables could be used to offset allowances for certain accounts. To put it simply accounts payable and accounts receivable determine whether there is actually enough money coming into your business.
So how does accounts receivable actually work? And what does a successful accounts receivable process look like? Well, firstly, you will invoice a customer for services rendered and this will (hopefully!) be paid into your business account within the stipulated timeframe. If the invoice is not paid in the allocated time, they become a bad debt impacting your cash flow. This could have far-reaching effects on your business growth and profitability.
If you aren’t a numbers person, then often an example is helpful to make the accounts receivable process that much clearer.
Example 1: On 1 January 2020 you sell jewellery worth 50000 to Joe Trader with a credit period of 20 days, a credit sale, if you will. That 50000 will be treated as accounts receivable against the Joe Trader account. Then, on 10 January 2020, Joe Trader pays 30000 to you. This means the receivable account against Joe Trader is decreased to 20000. If they pay the outstanding amount by 20 January 2020, then the debt is cleared on your financial statement. If not, debt collection processes will follow.
Example 2: Mary desperately wants to buy a lawnmower at a cost of 5000 but doesn’t have the money at the time of the sale. Lawnmowers R Us then invoice her for 5000 and record that amount in their accounts receivable. Mary is given 30 days to pay off that amount. If she does, then the money goes into the company’s cash flow. If Mary doesn’t pay off the amount and the money is still owed, Lawnmowers R Us are out of the money, and debt collection procedures will follow.
Your business can also offer accounts receivable financing which is a financial arrangement where you receive financing capital related to a portion of accounts receivable. These financing agreements can be structured using an asset sale or loan. This can get quite complex, and you should get some professional guidance for this.
You can partner with a software supplier to take over your accounts receivable process. This will automatically generate invoices and immediately update your system when a sale has been made, with an entry created to credit the sales account and debit the accounts receivable. Once a customer pays the invoice, the cash account is debited and the accounts receivable is credited. However, if a customer doesn’t pay the invoiced amount, then your automated system can send follow-up reminders to encourage prompt payment. The automatic chasing of overdue payments through to the collection process will keep your business in a healthy cash flow situation.
The collection period for accounts receivable differs from industry to industry and company to company. Often it’s around 30 to 60 days. However, this can be determined by monitoring your average collection period. If you are a fairly new business owner, then there are formulae available to assess the collection period.
First equation:
365 days x your accounts receivable balance ÷ by total net sales.
(A/R balance ÷ total net sales) x 365 = average collection period.
Example: ($50,000 ÷ $800,000) x 365 = 22.8 days average collection period.
Second equation:
365 ÷ days by your accounts receivable turnover ratio.
365 ÷ A/R turnover = average collection period OR 365 ÷ (net credit sales ÷ average A/R balance) = average collection period.
Example: 365 ÷ ($800,000 ÷ $50,000) = 22.8 days average collection period.
That’s not where the equations end! You can also measure how well your business is doing by working with the accounts receivable turnover ratio - also known as the debtor’s turnover ratio. This shows how effective your company is at collecting revenue which also indicates how efficiently you’re using your assets.
Accounts Receivable Turnover in Days
This shows you the average number of days it takes for your customers to pay for sales on credit. The formula for this is:
Receivable turnover in days = 365 / Receivable turnover ratio
While accounts receivable is important to business, management of this asset can take your attention away from business-enhancing solutions. Clearly, there’s a lot to be worked out with regard to equations, balance sheet monitoring, and debt collection. Fortunately, there is software available to automate this process. By partnering with a reputable organisation like Chaser, you can enjoy so many benefits such as:
The risk of not implementing a solid accounts receivable process is effectively the end of your business. If you’re a new business, Chaser can help you implement a process with smart accounting software that doesn’t incorporate manual invoices and outdated debt chasing. Rather, you can focus on your business’s core functions while the repetitive, time-consuming processes are taken care of.