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Accounts receivable (AR) can positively boost the overall profitability of a business, provided that dealings are done with reliable customers while enforcing specific terms.
No doubt, there’s a risk factor in credit-based transactions. But, the benefits they bring to a long term relationship with the customer can’t be ignored.
Read on as we dig deeper into the Accounts Receivable definition, process, and more.
What is Accounts Receivable
Accounts Receivable is the amount owed to a business for its products or services which are sold on credit. These credits are usually for a short period and are vital to every business. They can be listed under current assets on the balance sheet.
These entries will come in handy especially during audits to assess the revenue that the business has generated. This holds some amount of risk as well, which is why businesses tend to give out their products and services on credit only to other businesses that they trust.
Accounts Receivable helps build trust and strong credit relationships with customers. It also helps with determining the future cash flow of the business and can be shown as the collection capabilities of the business to any investor.
Importance of Accounts Receivable
Accounts Receivable needs to be managed efficiently for it to positively make an impact on your business. Here’s why.
AR allows regular and reliable customers to make consolidated payments, which reduces transaction costs when compared to a number of small payments. It also helps in increasing sales as it establishes a lasting working relationship with your customer.
AR provides a clearer image of a business’s profitability. Add up all of your assets, including accounts receivable, and deduct your total accounts payable, or liabilities, to calculate profitability.
The business is profitable if the amount is positive. If it is negative, then decisions on how to increase the assets or decrease the liabilities must be made.
Accounts Receivable process
There are four main steps to establish a typical AR process.
- Set up credit practices
- Create invoices
- Track received and pending payments
- Perform accounting for AR
As smaller businesses look to scale up, AR transactions tend to increase. The AR process not only helps in increasing accounting efficiency but also helps to create discipline while accounting for receivables.
Step 1: Set up credit practices
A business develops a credit application process which helps in determining if a customer is creditworthy. These terms include credit duration and interest in case of a delay in payment.
The whole process of availing credit should be informed to customers beforehand. Businesses should set a viable credit duration. The repayment tenure should not hamper business liquidity and profitability in the long term.
Since smaller businesses tend to have a lower cash flow, it is advisable for them to define shorter credit durations.
Step 2: Create invoices
An invoice containing all the information pertaining to the sale is created. It should have details such as products or services sold, the sale price of these products or services, GST rate applicable to such goods or services and the time duration for repayment.
It is advised that these invoices be created and sent to the buyer quickly. The longer it takes for the invoice to be sent, the longer it takes for the payment to be processed. Being prompt here is critical.
Step 3: Track received and pending payments
Generally, businesses have an AR/finance team whose job is to track AR payments. The officer dispatches invoices and follows up on the payments regularly.
Once the payment is made, it is immediately entered into the AR ledger. This documentation eliminates any confusion regarding the account.
Step 4: Perform accounting for AR
The AR/finance team tracks sales in a journal and calculates unpaid debt and early payment discounts.
This information is then passed on to debt collectors and audit teams to be entered in financial statements.
Track your Accounts Receivable effectively
It is extremely important to track Accounts Receivable as there are high chances of not billing a customer, giving away the products or services for free.
Here are 5 tips to effectively track your accounts receivable.
Communicate: Make sure to keep a track of pending payments and communicate with the creditor. Businesses that fail to communicate about pending payments within 60 days, tend to lose those payments.
Create a fool-proof internal process: Stay on top of your AR by creating an internal process to track and pursue creditors. Assign one day in a week to create, print, and mail invoices, and follow up on pending invoices the next day. This will create a continuous schedule which will help both the creditors and your business.
Confirm payment receipts: Make sure to send payment receipts while closing any receivable. This will help build your relationship with the creditor, and establish that all dealings are professional and well-documented.
Establish moderate terms for creditors: Businesses can extend a credit line for its customers. This can curb the risk factor in such transactions and also help with understanding both parties better. By sticking to the credit line, customers can establish their reliability and companies can also keep a check on all receivables.
Document everything: It is imperative that a business documents all the terms of the accounts to help bookkeepers with weekly or monthly inputs on their financial statements. Additionally, the documentation will come in handy if any legal pursuits appear.
Higher vs lower Accounts Receivable
Higher AR indicates that the business has poor collection methods and is having a tough time converting sales into cash.
Cash crunch might increase a business’s working capital requirement, which will lead to an increase in short term borrowings. These borrowings carry a high-interest burden affecting profitability.
However, lower AR implies that a business can easily receive cash from its customer and can use this cash for day-to-day operations. This allows the business to improve its cash flow, productivity and liquidity.
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