What is accounts receivable?
Accounts receivable is the total amount of money owed to a business for goods and services delivered. When you sell a product or service to another business, you can send an invoice for the amount to the purchaser instead of getting paid immediately. By offering invoice payment terms, you make it easier for customers to purchase from them, especially for business-to-business transactions.
The due date of the payment will depend on the merchant. The most common is 30 days, but it can be 15, 10 or 7 days from the invoice date.
By using accounting programs (such as Xero, MYOB and Quickbooks), you can quickly create a receivables report that shows outstanding receivable amounts by customer and how long they have been outstanding.
The challenges with managing receivables
Credit control policies are a typical way of managing accounts receivable. These include checking the credit history of the customer and requiring them to sign a credit agreement before offering invoice payment terms. If you do offer payment terms, how efficiently you collec receivables will influence your business cash flows. If too much debt is outstanding, or customers end up not paying (known as ‘bad debt’), the long-term prospects of your business could be in doubt.
Late payments are the biggest issue when managing accounts receivable. Research by Moula revealed that 65 per cent of SME customers don’t pay on time and almost 40 per cent of SME customers pay later than 30 days, regardless of the payment terms in place. It’s even worse when big businesses owe money to small businesses. Research conducted by Xero Insights showed that large businesses pay 53 per cent of invoices from small businesses late, by 23 days on average.
Despite the challenge it raises for vendors, offering products and services on trade credit is a longstanding practice for business-to-business transactions. Although the Moula research revealed that 63 per cent of SMEs have experienced negative cash flow impacts from late payments, 47 per cent said that their customers expect invoice payment terms. In addition, 34 per cent of businesses said that offering payment terms is an important selling point.
Balancing the benefits and challenges of offering invoice payment terms requires a professional approach to accounts receivables management.
Find out more about accounts receivable in What Are the True Carrying Costs of Accounts Receivable?
Determining the effectiveness of accounts receivable management
Fortunately, there are a few simple ways you can benchmark how effectively you are collecting the money owed to your business. One is called debtor days or average debtor days. This number shows you how many days on average it takes you to get paid after you have issued an invoice. So, if your payment terms are 30 days and it takes you 40 days on average to get paid, you are getting paid 10 days late. This delay will negatively affect your cash flow. To find out how to calculate this number, check out What Are Debtor Days?
Another way to analyse accounts receivable is called average accounts receivable. This number is calculated by adding the total accounts receivable amounts at the beginning and the end of each period, and then dividing them by 2. For example, if you want to determine the average accounts receivable for a financial year, you add the totals at the beginning and end of the financial year and divide by 2. If your receivables were $21,000 at the beginning of the year and $23,000 at the end of the year, the average accounts receivable would be $22,000 (($21,000 + $23,000) ÷ 2).
When you know the average receivables, you can calculate the accounts receivable turnover ratio for the period, which is:
(Total Amount of Credit Sales – Returns) ÷ Average Accounts Receivable.
If the total credit sales for the year were $230,000 and returns were $20,000, the accounts receivable ratio would be 9.55 (($230,000 – $20,000) ÷ $22,000). This means that the business collected its average accounts receivable 9.55 times over the year. A higher number indicates a business is effectively managing its receivables.
Using this information you can also calculate receivables turnover in days by dividing 365 by the account receivable turnover ratio. In this case it would be 365 ÷ 9.55 = 38.22. So, on average, it takes 38.22 days for invoices to get paid. If the company offers 30-day pay terms, this means it’s getting paid late eight days on average.
Ways to improve accounts receivable and cash flow
Effective accounts receivable begins with developing credit policies and procedures and implementing them. If your business has effective processes in place, you can avoid the stress of too many late payments and bad debts. Check out How to Protect Your Business with Credit Policies and Procedures to find out more.
Short-term business loans are another way to improve cash flow. For many businesses, there is a large gap between when they provide a product or service and get paid. For instance, accounting firms get paid 74 days, on average, after they start a project for a client.
Unsecured business loans are a popular way to cover short-term cash flow shortages because they do not not require collateral and can be approved faster than traditional business term loans.
With invoice finance, the accounts receivable of a business are used as collateral for a loan. The invoice finance company will analyse a batch of invoices and ensure that the debtors are likely to pay before providing finance, which is usually around 80 per cent of the value of invoices. Once the invoices are paid, the remaining amount is forwarded to the business, less any fees and interest. One of the drawbacks of invoice finance is its cost. Find out more in What’s the True Cost of Invoice Finance?
