What is Accounts Receivable?
Accounts receivable allow for a business to increase cash flow and move inventory quickly.
They are, essentially, credit sales.
When a business sells a product or service it has two main options for collections:
- Cash for the product purchased is immediately received
- Cash for the product purchased will be paid for in the future
The second option is also called a credit sale. Recording a credit sale will establish the accounts receivable (AR) account for a business. Then the business would track the credit sales, or receivable, on the AR subsidiary ledger. This ledger should be updated every time there is a credit sale or collection of cash.
Businesses earn revenue when they have a sale. Because of the way certain tax rules are written, there is a misconception that revenue isn’t recorded until cash has been collected. While this is correct for certain tax returns, this is not correct under the generally accepted accounting principles, also known in the accounting world as GAAP. When there is a sale, revenue is recorded for the business regardless of when cash is collected.
Set Credit Limits
Businesses should have credit limits for their customers. A credit limit allows a customer to make purchases up to a predetermined dollar amount. A new customer should have a lower credit limit until they have a proven track record of making payments. When customers show they are making payments then the limit can be increased. Most accounting software will allow businesses to set credit limits by each individual customer. These limits are safeguards from accidentally selling above a set limit.
The hardest part of dealing with AR is collections. It requires person-to-person contact that can become uncomfortable. The best thing to do is to set up a process in the accounting department to stay on top of collections. Follow up with customers 35 days after the sale and set a consistent schedule of follow-up until all money is collected. When AR gets to 50+ days past the sale or delivery, you are likely not going to collect the full balance. Once an account gets to 180+ days past due then collection becomes even less likely. Therefore, create a policy to follow up consistently and prevent these write-offs.
Collect Up Front
Depending on the product or service, try to collect as much up front as possible. Set a standard process on up front collection—even if it is only a percentage the final cost. The key is then to start training customers on this process. Your customers will adapt, and the business will see an improvement in cash flow.
Understand There Will Be Write-Offs
All businesses want to collect 100% of AR. However, there is bound to be a customer who doesn’t pay. When this happens, the account will have to be written off. The effect of this write-off has a direct impact to the bottom line of the business.
The concept of write-offs is not new. Many industries have a set expectation on the percentage of write-offs. In accounting terms this is call the Allowance for Bad Debts. If historical experience indicates a write-off of 2% of total credit sales every year, then there should be an allowance for 2% of AR on the balance sheet. While the allowance is an estimate, it will smooth the income statement if a significant write-off were to happen. Budgeting at the company level is key.
Analyzing Accounts Receivable
The numbers in the financial statements tell a story. To read this story, the numbers need to be converted into an understandable language. The language of AR revolves around cash and collection. This language is understandable through the incorporation of certain Key Performance Indicators (KPIs). The most used KPIs are:
- AR turnover
- Days sales in AR
Accounts Receivable Turnover
AR turnover is a mathematical calculation. This calculation analyzes the number of times a business collects their average AR in one fiscal year. A high turn-over indicates good collections efforts and high-quality customers. A low turn-over indicates opportunity to collect older AR as well as inadequate collection efforts. The number to be considered as high or low will depend on the industry. While a turnover of 4 times may be high for one industry, it may be low for another. The formula for AR turnover is:
Net annual credit sales ÷ ((Beginning AR + Ending AR) / 2)
An example of the calculation is:
$2,000,000 Net Credit Sales ÷ (($300,000 Beginning AR + $250,000 Ending AR) /2)
= $2,000,000 Net Credit Sales ÷ $275,000 Average Accounts Receivable
= 7.2 Accounts Receivable Turnover
In this example, the accounts receivable turns 7.2 times during the past year. If, in this example, the industry norm is 6 times, then this calculation of 7.2 indicates a good collection rate and excellent customers. If the industry norm is 12 times, then the opposite can be said for a turnover of 7.2. Having the industry average in AR turnover is key to understand how well a business is accomplishing collections.
Days Sales in Accounts Receivable
Days sales in AR is the number of days it took a company to collect on their average AR. Calculate days sales in AR as follows:
Days in Year ÷ Accounts Receivable Turnover (See Previous Formula)
In our example above, the days sale in accounts receivable is:
365 Days in year ÷ 7.2 accounts receivable turnover = 50.6 days.
This means that the average AR was collected in 50.6 days. Again, having the industry average days sales in AR is key to understanding how well a business is doing on collections.
A virtual controller or chief financial officer will have the resources to determine the KPIs for each individual businesses industry.
- Understand accounts receivable is a credit sale
- Set credit limits for customers
- Train customer and follow-up consistently on receivables
- Collect up front if possible
- Obtain an understanding on accounts receivable turn over and days sales in AR.
Hovland Forensic & Financial has fractional CFOs and controllers who help businesses analyze credit policies and accounts receivable ratios through expert outsourced accounting services. We help a small business stay on top of accounts receivable and other common bookkeeping tasks. Contact us today to get started on boosting the cash flows of your business.