Accounts receivable collections is the process a business undergoes to ensure that customers follow through on payments for services or products provided.
Collections can take on many different approaches depending on the business, the customer, and the accounts receivable.
Accounts receivable (AR) is an accounting term that refers to sales for which payment has not yet been received. The customer has not paid for the good or service received at the time of the transaction. Instead, the business has extended credit to the customer and expects to receive payment for the transaction at some point in the future.
Accounts receivable are typically collected in two months or less. For this reason, they are considered a “short-term asset,” which refers to any financial resource that can be converted to cash in one year or less.
While in the perfect world all accounts receivable will be collected in the standard amount of time, in reality, this is not always the case. The business can and must take different proactive measures to remind and encourage customers to follow through with payment. These measures help the business ensure that uncollected debts are kept to a minimum.
A business that does not have an effective process for collecting accounts receivable will not have sufficient cash flow and may not be able to meet its basic obligations.
There are many proactive steps a business can take to support its accounts receivable collections.
One of the essential elements of effective AR management will be the steps the business takes to extend credit to its customers.
Having a detailed and well-conceived process for approving customer credit will ensure that the business is extending credit to reliable customers who will be more likely to pay on time, minimizing both the risk that the business is exposed to and the demands that may be placed on AR staff by having too many accounts that are in arrears.
Proper invoicing with a AR collection management software also supports AR collections. Invoices that are accurate and clear about the terms of payment will help to avoid confusion. The invoice should include all the terms that were agreed to at the point of the transaction.
Accounting automation greatly improves the process of accounts receivable collections. Accounting automation, also known as computerized accounting, refers to the use of software applications to perform the essential functions involved in the process of maintaining a business’s financial records. Automation greatly reduces the time, labor, and costs involved in AR. Most importantly, it improves efficiency and accuracy, which help improve collections.
Beyond these steps which lay the foundation for good accounts receivable collections, the business will also want to evaluate its accounts receivable by creating what is known as an aging report. An aging report will provide the business with a snapshot of the status of all its accounts receivable.
The aging report organizes individual accounts receivable into groups depending on how much they are past due. The typical groupings are:
more than 90 days
The status of each group reflects the time that has elapsed since an invoice was issued to the customer. The aging report will help the business organize and evaluate the status of its accounts receivable.
Once a business has evaluated its accounts receivable, it can implement a strategy for collections. Accounts receivable teams use dunning letters to collect on overdue receivables and prevent accounts from going delinquent. A dunning letter is a collection notice sent to a customer explaining that a payment they owe is overdue. They help the business communicate with its customers and prevent delinquent accounts.
Business can also take many steps to avoid having accounts receivable become past due. The business must move quickly on accounts receivable to avoid letting them go uncollected for a longer period of time. Discounts for early payments, payment plans, and offering diversified options for receiving payments also help the business manage collections and keep uncollected payments to a minimum.
Businesses measure their accounts receivable collections by calculating the accounts receivable turnover ratio. This ratio measures how effectively the business converts outstanding debt from customers into completed payments. In other words, it measures how effectively the business is able to collect payment on its accounts receivable.
The accounts receivable turnover ratio is calculated as a fraction. The calculation takes two steps. The first step involves adding the balance for accounts receivable at the beginning of the reporting period to the balance at the end and dividing by 2. This produces the average value of accounts receivable for the period.
The second step involves the creation of the actual fraction, or ratio. The calculation starts with the total value of sales on credit for the accounting period and divides this figure by the average value of accounts receivable that was calculated in the first step. This produces a fraction or ratio of total credit sales to accounts receivable.
A larger number is a good sign for the business, while a smaller number is a bad sign. In other words, a high turnover ratio means the business is converting a higher proportion of its credit sales into cash, and a lower turnover ratio means it is converting a smaller percentage of its credit sales into cash.
Businesses also measure collections by calculating the Days Sales Outstanding (DSO), which refers to the average number of days it takes a business to collect payment for products and services provided. DSO is generally taken as a measure of the business’s efficiency and its effectiveness at converting sales to actual revenue, or cash. The lower the DSO, the more efficiently the business is operating.
The DSO is calculated simply as the value of the accounts receivable divided by the total number of sales on credit, then multiplied by the number of days. The equation is represented mathematically as:
In this manner, the DSO is essentially a representation of the total amount of payments to be collected as a proportion of the total amount of credit that has been extended over a period of time. The product represents an average for the amount of time it takes during the accounting period for accounts receivable, or credit sales, to be collected. In this equation, the number of days represents the number of days in the accounting period.