What are accounts receivable?

Accounts receivables (AR) are a critical component of a healthy financial ecosystem for businesses worldwide. A well-managed accounts receivable department provides several benefits to a business, such as improved cash flow, reduced bad debts, enhanced customer relationships, and more efficient operations. This article will provide the accounts receivable definition, discuss how it works, and how it fits into the overall financial picture of a company.

Accounts receivable refers to the outstanding invoices or money owed to a company by its customers for goods and/or services provided on credit. In simpler terms, it is the amount clients owe a business for products or services delivered but not yet paid for. AR is also the name of the function responsible for collecting payments owed to the company by its customers.

Accounts receivables are considered an asset on the company's balance sheet, representing a legal obligation from the customers to pay the amount in question. 

Accounts receivables are essential to the success of a business, no matter its size. This crucial aspect of financial management can make or break a business.

Here are a few reasons that AR is important:

• Positive cash flow - Ensuring enough money flows into your business is essential for growth and stability. When receivables are efficiently managed, businesses can provide for their ongoing operational needs, pay off debts, invest in growth, and ultimately, make profits.
• Healthy business relationships - When customers consistently pay their invoices on time, it's a sign of a fruitful partnership. It's about fostering that trust and being able to rely on honouring agreements.
• Liquidity - Efficient AR management improves your business's liquidity, which in turn helps secure loans and funding. Financial institutions typically closely examine a company's accounts receivable when determining its creditworthiness.
• Predictable revenues - The less time and energy a business spends worrying about collecting payments, the more mental space it has for growth, innovation, and other business operations. A streamlined accounts receivable process enables predictable cash flow and enhanced financial planning. 

The AR process begins after a customer places an order for goods or services that your business provides. Typically, the customer will send you a purchase order (PO), which details the goods/services ordered, the quantity, and the agreed price of the items. 

Once the PO has been approved, a sales order (SO) is created. A sales order is a binding commercial document that includes the order details and confirms the sale. SOs also typically include the expected delivery date, delivery address, and payment terms.

Prior to sending the SO to the customer, your credit department will review it to determine whether credit terms can be established for the customer. Credit terms are the conditions under which a company extends its products or services to a client on credit. Once credit is extended, the sale is recorded, with the client as the debtor and the company as the creditor.

The next step in the process is for the AR team to issue an invoice to the customer. The invoice details the goods or services ordered, the amount due, and the payment terms. Payment terms specify the period within which the customer is expected to pay, commonly set as a net 30, 45, or 60 days from the invoice date. Businesses often require a deposit upfront for large purchases or if the item is produced to order. Companies delivering services typically bill for some portion of their fees in advance.

The AR team then manages the collections process to ensure prompt payment from the customer. If a customer's payment is past due, collection efforts are initiated by the company, typically through friendly reminders via email, phone, or letter. In the case of significantly overdue payments, more aggressive collection tactics might be employed, such as employing a collection agency or taking legal action. If collection efforts fail, you must write off the receivable as bad debt.

AR teams are also responsible for addressing any disputes relating to invoices. Invoice disputes are any issue that prevents the payment of part or all of an invoice, and they are an inevitable part of the AR process. Common customer disputes include:

• Pricing: a difference in pricing between the agreed amount and the final charge
• Quality: the quality of a product or service billed on an invoice is in question
• Administrative: documents related to the purchase are missing or incorrect
• Payment terms: pricing terms, such as due dates, are in dispute

Once payment is received, the  AR team records it in their accounting system. The transaction is recorded in the receivable ledger as a credit, and the amount is deducted from your remaining unpaid receivables balance.

Understanding the differences between accounts receivable and accounts payable (AP) is crucial for managing a company's financial health. The direction of the cash flow is the primary difference between accounts payable and accounts receivable.

Accounts receivable represents the amount of money a company is owed by its customers for goods or services it has provided on credit. This means the company has delivered the products or services but has yet to receive payment. As a company generates sales, its accounts receivable balance will increase, indicating that it has outstanding bills that it expects to collect from its customers in the near future. Timely management of accounts receivable is critical for maintaining cash flow and ensuring a steady income stream.

On the other hand, accounts payable refers to the money a company owes to its suppliers or vendors for goods or services it has received but has not yet paid for. Accounts payable typically result from purchases made on credit, wherein a company acquires products or services to fulfil its operational needs, with the agreement to pay for them at a later date. Managing accounts payable effectively is also vital for a business, as timely payments to vendors help maintain strong relationships with suppliers and avoid late payment penalties or damage to a company's creditworthiness.

A healthy accounts receivable speaks volumes about the overall financial health of a business. Tracking accounts receivable is crucial for maintaining accurate financial records and cash flow projections. 

Companies that struggle to collect their accounts receivables in a timely manner may face serious cash flow problems, ultimately affecting their ability to support daily operations. In fact, one study found that 82% of companies that were forced to close their doors attributed their downfall to cash shortages.

Businesses can implement various strategies to ensure the timely collection of outstanding receivables, including invoicing, offering early payment discounts, and closely monitoring aging reports to identify potential collection issues.

Tracking the days sales outstanding (DSO) provides insights into how healthy a business’s cash flow is. DSO is the average number of days it takes a company to collect payment after a sale has been made. The longer a company must wait for payment for services rendered or products delivered, the less cash the business will have to cover expenses or fund growth.

Trends in DSO are very important because they can indicate if there is a cash flow/payment problem or if DSO is within standard variation or fluctuation. DSO is typically reported and evaluated monthly, quarterly, and annually. It’s important to understand DSO trends over a 12-month period because your numbers may vary month to month due to natural business cycles or the seasonality of your business.

Download our white paper, Top 7 Features Every Automated AR Solution Should Have , to learn more about choosing the ideal solution to reduce DSO and to have the biggest impact on your business.

Accounts receivable is an essential component of a company's financial management. Understanding the process of accounts receivable, from issuing invoices to collecting payment, is essential for effective cash flow management. By properly managing accounts receivable, companies can ensure they receive the funds needed to support operational expenses, capital investment, and growth. Therefore, accounts receivable is not just a financial metric but a key indicator of a company's financial health and overall success.