Businesses get paid in one of two ways. Either the business takes payment for good and services before providing them or it provides the good and services prior to payment. In the first instance, we’re talking about retailers or barbers. These people don’t let you out of the door without paying.
In the second case, you end up with bigger businesses and more complex products. Consultants, home builders, and auto dealers all accept some form of delayed payment.
Any business that collects payments after the fact is going to have an accounts receivable department and an accounting entity of the same name.
What is accounts receivable?
In simple terms, accounts receivable represents the credit that has been extended to a customer in exchange for a good or service. It is usually different than the credit a financial institution offers, in that it’s not just a pool of hypothetical money to spend.
Accounts receivable – often called AR – is the money that a business is owed. It’s an asset that businesses can leverage to finance their operations and it has risk associated with its value.
We’ll look at some typical accounts receivable scenarios and talk about ways to manage accounts receivable.
Examples of accounts receivable in real life
Tom runs a web design business. He works like many small businesses, billing clients a portion of the agreed amount up front, a portion midway through the project, and then a final portion with any adjustments at the end of the project.
As such, Tom often has bills that he has sent out but that have not yet been paid. These bills collectively are Tom’s accounts receivable. If he is owed three bills, for instance, of $400, $250, and $600, his accounts receivable would total $1,250.
This is an asset for Tom’s business. It’s money that is owed to him and that he needs to collect. If he’s been paying attention, Tom will know how long all those bills have been outstanding and will have some plan in place to communicate with the clients and collect the money.
While Tom has not yet collected the cash and these outstanding bills are essentially credit, the last thing a small business wants to do is to start treating its AR like a credit issuing function. Bills take time to pay, and some people will wait until the last minute to pay every bill. That’s not the same thing as saying that someone can take as long as they please to pay your business back, but you’re going to change them some interest rate. Issuing credit is not what your small business should be up to – unless that’s your business.
AR is a credit in name only. Your goal, as a small business, should be to collect the cash you’re owed as quickly as possible.
Accounts receivable turnover ratio
One of the best ways to measure the effectiveness of your account collection is to track your accounts receivable turnover ratio. This is the number of times in a year that you collect your average accounts receivable outstanding balance.
For instance, if your business is usually owed $5,000 and it collects $80,000 in receivables in a year, your accounts receivable turnover ratio is 16. Notice that you’re not taking your total revenue into account here.
Tom collects about a third of his revenue before the job begins. That’s not money that ever enters into his AR system. As such, he won’t add it into his turnover ratio since the ratio is supposed to measure his ability to collect on his debts.
Best practices for managing AR
Making sure you collect on time is a three part project.
- Set the expectation. Every communication regarding a bill or payment should include a clear deadline for the client. Any payment options should be outlined and any late payment fees should be called out. No client should ever say, “You never told me…”
- Monitor your outstanding bills. Managing an effective AR system is all about knowing where things are and when things are coming due. You should have all of the relevant information in one place so you can make quick decisions and track any detrimental trends.
- Communicate sooner rather than later. The goal of your business is to turn action into revenue as quickly as possible. If someone has a bill coming up, remind them. If someone has a bill overdue, chase them. Always reach for the phone before you absolutely have to.
All of this is about moving information easily around your internal system and between you and your clients. Plenty of accounting and accounts receivable software vendors now provide the tools to make these interactions as easy as possible.
You can now send email invoices, accept payments online, set auto reminders, and even setup customer portals for clients to view their bills and payment histories. These tools give you all the resources you need to take the hassle out of AR management.
Final thought on AR management
Managing your outstanding debts is key to keeping your business running. Not just because it means getting the cash you’re owed, but because it means having a good rapport with your customer.
There are other knock-on benefits of AR management, as well. If you can get a firm enough hand on things, you can even borrow against your existing invoices.
If you’ve had a great accounts receivable turnaround, let everyone know your tips in the comments below. If you’re still trying to get a handle on things, check out Capterra’s finance blog for more tips or swing by our accounting software directory for some digital assistance.
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