A step-by-step guide to the accounts receivables process
Every action, explained simply with flow charts and examples.
The accounts receivable process includes all steps from receiving an order to getting paid. It can be complex, but it is absolute crucial to manage it effectively for your company's financial health.
Below, we discuss what the AR process is, how you can measure its effectiveness, and how you can improve your process to enhance cash flow and improve you business operations.
Key takeaways
- Accounts receivable is money owed to a business
- The AR process starts with a request for goods/services to collecting payment
- The AR process is crucial to maintaining your cash flow, working capital, and meeting your financial obligations
- A successful AR process will minimize late payments, maintain accuracy, and encourage early payments
- You can assess your AR process using metrics like DSO, AR turnover, and the average collection period
- Automating your AR process improves efficiency, handles otherwise manual tasks, and minimizes errors
What is accounts receivable?
Accounts receivable (AR) are the funds owed to your business by customers for goods or services delivered but not yet paid for.
This amount is recorded as a current asset on your balance sheet, indicating that it is expected to be converted into cash within a year.
AR includes invoices issued to customers, credit sales, and other outstanding payments.
What is the accounts receivable process?
The accounts receivable process — also called AR process or receivable cycle — covers the steps to collect payments from customers for goods/services you've delivered.
This includes sending invoices, tracking payment due dates, and recording payments when they're received.
The process overall plays an important role in your overall business operations: understanding when money will come in — reliably — helps forecast future cash flows so you can plan investments, purchases, and other things to improve your business.
Why the AR process is so important
The accounts receivable process is important because it impacts your cash flow and liquidity.
An efficient AR process keeps cash coming into your business, meaning you can meet your own financial obligations and put your money where it can benefit your business most.
The accounts receivable process explained
The accounts receivable process includes all steps for handling and recording receivables.
Step 1: Receive order
The AR process starts with receiving a purchase order, whether that be a B2C or B2B payment. Once the order is approved, an agreement called a sales order is created, which details all the information about the purchase.
Step 2: Credit approval
Assessing customer creditworthiness ensures payment for goods/services. Outstanding invoices can cause cash flow issues and hinder meeting your own financial obligations.
New customers
You should have a credit approval process that assesses the customer's trustworthiness and ability to pay for their requested goods or services. This credit approval for new customers should take into account payment and credit history, capital, and current conditions.
Existing customers
It's vital you continue to monitor the creditworthiness of existing customers. Pay attention to any changes in behavior or patterns, to ensure you're not taking on extra risk.
Step 3: Send Invoices
The next step is to send the customer an invoice, which will detail how much money they owe and the payment terms. This includes the payment due date and any fees for late payments. This is the step when AR is recorded as a debit on the balance shit.
Step 4: Manage collections
Inevitably, you will end up with some late, unpaid invoices. It's then your goal to improve your chances of collecting money by having your staff follow up with the customer, and possibly escalating things if necessary.
Before reaching out to customers who are past due, ensure that the invoice was actually sent and is error-free.
You might want to review their payment history — if they're typically reliable then it might be a slip-up. Treat each case within the context of you and your customer's relationship.
Step 5: Address disputes
Issues with orders or incorrect invoices can cause disputes and late payments.
According to VersaPay, 50% of disputes are due to human error, so it's often best to understand the root cause before assuming the "worst."
It's crucial your team handles disputes early so payments aren't delayed and relationships are maintained.
Step 6: Process payments
Finally, receive payments by offering customers various payment methods to encourage timely payments.
Different types of payments
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Credit cards. A credit card are, of course, a very popular way to make payments for various things. They offer convenience and the ability to build credit, but can have high processing fees.
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ACH. Automated Clearing House, or ACH, is an electronic fund transfer between bank accounts. ACH payments are secure, convenient, and often cheaper to process, but have slower processing times.
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EFT. Electronic Funds transfer, or EFT, is a digital money transfer between bank accounts. EFTs are cost-effective and faster to process, but can have higher transaction fees. Read more about the differences of EFT and ACH payments.
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Checks and echecks. Paper checks are a traditional payment method that physically sends bank information to then facilitate a transfer of funds. EChecks are similar to paper checks, but the transfer of information is done digitally. This payment method is reliable and cost-effective, but can have slower processing times. Learn how accept check payments online.
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Wire transfers: Wire transfers are electronic funds transfers known for their speed and reliability, often completed within the same day. They can be more expensive due to higher transaction fees for both the sender and receiver and are commonly used for large, urgent payments.
Once a payment has been received you'll have to record the revenue and reconcile it in your accounting process software.
On your balance sheet, credit accounts receivable to decrease it and debit your revenue account by the same amount.
What does success look like in the AR process?
A successful AR process collects payments efficiently and on time, meaning cash flow and working capital are predictable and reliable.
Signs of an efficiently managed AR process include:
- A high rate of early payments
- Invoices are accurately sent in a timely manner
- Minimal late payments
- Policies are proactive with late payments
The top metrics and KPI to measure the success of your AR process
Monitoring your AR performance can be a key insight into your company's financial health. Some of the stats you should keep an eye on include:
AR turnover ratio
Your AR turnover ratio measures how effectively your business collects debt and extends credit. AR turnover ratio is calculated by dividing your net credit sales by your average accounts receivable. The higher your ratio is, the better.
Expected cash collections
Expected cash collections calculate the projected amount of cash to be received during a period. To calculate your expected cash collection, add your cash sales and estimated AR collections.
To estimate your AR collections, first deduct the expected amount of receivables you won't collect. Then group your receivables into 30, 60, and 90 days buckets. Analyze your average payment history to create an AR aging report, which will give you an estimate of the rate of collection for each bucket. Finally, multiply your collection rate by the receivables balance in each bucket.
Average collection period
Average collection period measures the average time it takes to collect a payment that is owed.
Calculate the average collection period by dividing. a yearly accounts receivable balance by yearly total net sales, then multiplying by 365 to get the number of days.
Days sales outstanding
The days sales outstanding, or DSO, calculates the average number of days it takes a company to receive payment.
To find your DSO, divide your total AR by the total credit sales in the same period, then multiply the result by the number of days in the period.
Collection effectiveness index
The collection effectiveness index measures how effective a company is at collecting payments on time. To find this number, divide the company's total AR by its total sales.
Average days delinquent
Average days delinquent, or ADD, represents the average amount of days payments are overdue.
You can use ADD to analyze the trends of your AR effectiveness and your customers' creditworthiness.
This may sound similar to DSO, but DSO looks at how long on average customers take to make a payment, whereas ADD only looks at payments that are late.
1. To find the average days delinquent, firstly calculate your DSO:
DSO = (Accounts Receivable ÷ Total Net Credit Sales) x Number of Days in Period)
2. Then, find the best possible DSO (BPDSO):
BPDSO = (Current Receivables x Number of Days in Period) ÷ Credit Sales for Period
3. Finally subtract your BPDSO from your DSO:
ADD = DSO - BPDSO
Number of revised invoices
The number of revised invoices looks at how many invoices your team has had to revise in a period. This can help you determine your process' accuracy.
To find the number of revised invoices, simply count how many invoices had to be modified within any given period.
Percentage of bad debt
Bad debt represents money owed by customers that is uncollectible. It is inevitable that you'll run into some bad debt, so it's crucial you understand how to manage it.
To calculate your percentage of bad debt:
% of Bad Debt = Total Bad Debts / Total Credit Sales (or Total Accounts Receivable)
Once you've calculated your rate apply it to your current credit sales to estimate how much of your AR would be allocated to a bad debt allowance account.
This figure helps you understand how effective your collection process is. Aim to keep your bad debt percentage as low as possible.
Staff productivity
Staff productivity shows how effective your AR collection process is compared to the effort your staff puts in.
Calculate it by dividing the number of goods or services produced by the total hours worked during a set period.
Customer satisfaction
Monitor customer satisfaction to ensure throughout your AR collections process you are maintaining positive relationships with customers.
Benefits of automating accounts receivables cycle
Security and compliance
Automating your AR process will make it digitized, often on a cloud-based solution. Cloud-based solutions centralize your data so you don't have to worry about lost documents and offer extra security by encrypting your information.
Additionally, a digital process creates a trackable trail for your AR that you can use for audits and reporting.
Speed and efficiency
Automation improves the speed and efficiency of your AR process by handling tedious tasks. For example, Plooto Capture streamlines your invoice management by automatically uploads invoice data, saving time on manual entry.
Consistency and accuracy
By taking over manual tasks, which are often error-prone, this improves the accuracy at which your AR process is completed. Automation also helps keep your process consistent by enabling you to create standardized policies and an improvement in accuracy.
Cash management
When your AR process is automated, you can better predict cash inflows, leading to improved forecasting and budgeting.
Accounts receivable best practices
Every AR process is slightly different, and different companies should do what works best for them. But there are still some basic best practices to follow that will get any company moving in the right direction.
Provide an estimate/quote
Before signing a sales order, consider sending the customer a quote which includes the goods/services to be sold, the price and payment terms. This can help customers have a better estimate how much they owe and when they owe it, so they can better prepare for sending a payment. This can also help speed up the invoice approval on their end.
Create a follow-up policy
Establish clear communication points with customers regarding their payments. This often includes sending reminders before their due date and following up when payments are overdue.
Standardized policies help minimize bad debt and keep your customer relationships positive.
Establish key performance indicators
Establish KPIs for your team that can help you improve the efficiency of your process.
For example, you might aim for a minimum AR turnover ratio that meets your industry's standard, or a lower average days delinquent to help improve your collections process.
