Accounts receivable management is the process by which a business oversees and administers the collection of outstanding payments from its customers. How this is done can have a significant impact on the business.
Accounts receivable (AR) refers to the sale of products or services for which payment has not yet been received from the customer. The customer did not pay for the good or service at the time of the transaction. Instead, credit was extended to the customer and the business expects to receive payment(s) for the transaction at some point in the future.
AR is an important part of the accounting process in any operation. They represent convertible assets owed to the company. That is, they reference a financial resource that can be converted to cash in the near future, once the customer has paid.
Similarly, they are the basis for measuring the business’s ability to convert sales into cash. When payments are not collected for accounts receivable, this is an indicator that the business is not performing as well as it should. Therefore, how accounts receivable is managed is an important function because this affects the revenue stream coming into the business.
Several components make up the process of AR.
The first step in recording accounts receivable is the invoice.
This is a document produced by the business to record the details of a transaction.
The information contained in the invoice is essential to both the business and the customer and contains all the vital information related to the transaction.
As it relates to accounts receivable, an invoice will also contain important details about the terms of payment for the transaction.
A well-prepared invoice, with important information that is documented and conveyed clearly and concisely, is an essential building block of effective AR management.
A poorly composed invoicing process, on the other hand, will undermine the organization's ability to effectively manage accounts receivable because it does not clearly and proactively communicate payment information to the customer.
Another basic element of AR is credit. Businesses that have accounts receivable, which is most, do so because they have extended credit to their customers.
Limited business models operate on a cash-only basis.
Extending credit to customers is good practice for most businesses. It expands the pool of potential customers who can purchase goods or services, and it gives them greater payment options.
Credit also builds trust and goodwill between the business and its customers, which contributes to customer loyalty and retention.
All credit comes with some degree of risk, so an important part of AR management is having a well-developed set of credit policies in place.
Credit policies include such important guidelines as the criteria used for evaluating customers' credit worthiness, limits on how much credit may be extended, and the terms for repayment of credit.
A good set of credit policies will help the business extend constructive and reliable credit to its customers while minimizing the risk of default.
Payments for AR must eventually be collected, and an important element of effective management is a well-run collections process.
This includes issuing dunning letters, which are collection notices sent to customers explaining that a payment they owe is overdue.
AR management must also include a process for working with collections agencies for those instances when accounts are determined to be uncollectible.
Cash application is the process of matching incoming payments to outstanding invoices and to the proper account where they can be entered in the general ledger.
It’s an essential way for businesses to track cash flow and capital so that funds can be utilized efficiently, accurately, and quickly.
Incoming cash can’t be utilized by the company until it has been properly assigned, so effective and timely cash application is an essential element of any accounts receivable management.
Good AR management also involves metrics. It is important to measure the various inputs and outputs of accounts receivable to support actions and to evaluate their effectiveness.
Many different metrics are used.
The receivables-to-sales ratio measures accounts receivable in proportion to its sales for a given period of time. A high number shows that a greater number of sales are generating accounts receivable, as opposed to cash. This reveals a higher level of risk in the customer base and is not always a good sign for the business.
The receivables turnover ratio is the inverse of the receivables-to-sales ratio. It measures sales as a proportion of accounts receivable. In contrast, a higher number reveals a better success rate in collecting payments, which is a positive sign for the business.
Finally, days-sales-outstanding is calculated as the average number of accounts receivables divided by sales and then multiplied by 365. This ratio shows how long it takes a company to convert its receivables into cash.
The processes and metrics mentioned above contribute to the overall management of accounts receivable. Relying on traditional, manual-entry applications can be detailed, time-consuming, and labor-intensive.
However, accounting automation helps businesses streamline these processes by minimizing or even eliminating the tedious, manual-entry steps that are involved.
In this way, modern, digital accounting help businesses enhance and improve their management of accounts receivable.
For example, electronic invoice presentment and payment, or EIPP, is the electronic delivery of receipts and receipt of payment.
It can greatly streamline the invoicing and payment process for businesses and consumers, and it can improve AR management by digitizing the corresponding records and journal entries.
Maintaining customer master data, and storing it in a centralized data-based system, is another example of how modern accounting can improve accounts receivable management.
Maintaining this data can cut down on redundancies and manual entry in the keeping of records pertaining to accounts receivable. Storing it centrally can raise efficiency and reduce the processing time of tracking accounts receivable and collections of payments.
AR management is important because it impacts many different aspects of the business and its overall health.
For example, properly evaluating credit worthiness of customers and maintaining sound policies for extending credit can significantly impact the level of risk that the business exposes itself to as well as its ability to convert sales to cash.
The efficiency of a business's cash application can determine how well and how quickly it can assign cash to the proper transactions and put that revenue back to work for the business
AR management faces many challenges that can slow and undermine its effectiveness. Poor communications between the business and customers can impact the business's ability to follow through on payments due.
Not having well-defined policies and practices in place, especially as they concern credit and collections, can hinder the business's ability to collect payment and sour relationships with customers.
Finally, legacy applications used in accounts receivable management are often time-consuming and labor-intensive. They do not provide the business with the latest features in data-based management or offer them the fastest and most efficient means of processing information.
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