A Beginner’s Guide to Accounts Receivable

Some industries, such as retail and food service, operate primarily on a payment at the time of service basis.

However, most business-to-business transactions are made on credit. This means goods or services are delivered before payment is received.

Accounts receivable is how businesses track the money that is owed to them for goods or services that have been delivered but not yet paid for.

What Is Accounts Receivable?

This term refers to an asset on your balance sheet and revenue or sales on your income statement in accrual accounting systems.

It represents the total amount of money owed to you by customers for goods and services. Because cash accounting systems do not recognize income until it is received, they do not have accounts receivable.

How Are Accounts Receivable Processed?

The processing of this asset takes multiple steps:

1. Create a Credit Approval Process

Before you can accept credit payments, you must first decide to whom you are willing to extend credit.

You can choose to allow anyone to pay on credit, but this runs the risk that too many of your customers will not pay on time, which can create cash flow problems.

More commonly, businesses require a credit application and decide whether to extend credit based on the customer’s credit score, past payment history and overall financial health.

2. Create and Send Invoices

Sending out timely invoices helps you receive timely payments. It is usually best to send the invoice immediately.

The invoice should include the amount due and the payment terms. You can increase your collection efficiency by automating this process.

3. Track Your Accounts Receivable

You can reduce the occurrence of late payments and nonpayment by keeping track of your accounts receivable and being proactive in your collection efforts.

Send customers a reminder when their due date is approaching and another if they miss their due date. Automation can also help with this step.

4. Post Payments

Once you receive a payment, post it as a deposit or set up your accounting software to do this automatically.

What Are Typical Payment Terms?

There are several common types of payment terms that most businesses offer to customers. Some types do not result in an accounts receivable balance. 

Net Terms Payments

One of the most common payment terms is Net Terms Payments. This refers to the number of days the customer has to pay the invoice in full.

The common Net Terms is COD/Pre-Paid, 7, 14 and 30 days. For example, if the customer has 30 days to pay, then that is a Net30 payment term. To avoid confusion, many businesses have moved away from this terminology on invoices and simply list the date that payment is due.

X Days End of Month (EOM)

To make it easier on cash flow and also to save time by raising all invoices at the end of the month, some companies offer 7/14/30 End of Month. 

This allows their customers to order throughout the month and the invoice for all orders for the month will be raised at the end of the month and due in X days from the last day of the previous month.

You will see 7 Days EOM, 14 Days EOM and 30 Days EOM as the most common abbreviations for these terms.

What Are the Benefits of Accounts Receivable?

From a record-keeping standpoint, accurate accounts receivable records are an important part of establishing an accurate summary of your company’s assets on its balance sheet.

Without accurate AR records, you may have a difficult time determining your cash flow, allocating funds, paying expenses and obtaining financing or investments. Additionally, inaccurate records can result in audits and penalties.

In terms of your business operations, accounts receivable make it possible for you to expand your customer base by selling to customers who do not want to have to make immediate payments.

While only accepting immediate payments can make it easier to manage your cash flow, it can restrict who you can sell to because most businesses expect to be offered credit terms.

What Is an Allowance for Doubtful Accounts?

No matter how good your vetting process is, you will have customers who do not pay their invoices.

This can happen for a variety of reasons, including economic downturns, cash flow issues, poor record-keeping, bankruptcy or going out of business. 

Your allowance for doubtful accounts is an estimate of what percentage of your accounts receivable will not be paid. It reduces the value of this asset and helps to provide a more accurate picture of your cash flow and overall financial health.

How Can I Use Accounts Receivable To Gauge My Financial Health?

Two related ratios can be useful for gauging your financial health.

These ratios are useful for internal evaluations and may also be considered by lenders or investors who are considering providing you with capital.

AR/AP Ratio

Accounts payable represent the money that you owe to other businesses.

Your AR/AP ratio is the total amount of your accounts receivable compared to the total amount of your accounts payable. A 1:1 AR/AP ratio means you are bringing in just enough revenue to cover your expenses.

This is a risky way to operate because if your clients do not pay on time, you may not have enough money to pay your creditors.

An AR/AP ratio of 2:1 is considered healthy and a ratio of 3:1 allows you to budget some of your funds for reinvestment or savings.

AR Turnover Ratio

The AR turnover ratio is your net credit sales divided by your average accounts receivable.

This ratio is used to gauge how efficient you are at extending and collecting credit. If your ratio is high, this indicates that you are conservative about extending credit or more aggressive about collecting amounts owed.

It also indicates that your business is earning enough revenue to cover expenses, even when you account for clients who pay late.


How Can Pencil One Help Me With My Accounts Receivable Process?

Our software automates your wholesale applications, trading terms and payments.

This can speed up the process of applying for credit for your customers, which may increase your sales.

It also requires customers to enter bank or credit card details at the time of application so that customers can be billed automatically.

By using our software, you can reduce late and missed payments without having to chase invoices around. To find out more about how we can automate your accounts receivable process, book a demo with us!