Accounts receivable: ultimate guide for small business owners
Accounts receivable is one-half of the accounting equation along with accounts payable. Together they form the backbone of your cashflow management.
In this guide, you'll learn:
what accounts receivable is
how it differs from accounts payable
how the accounts receivable process works
what happens if clients don’t pay.
What is accounts receivable?
Accounts receivable is the money customers owe you. The moment you send an invoice, it becomes a part of your receivables, until it's paid.
Accounts receivable refers to both the money owed and the process of collecting it. The accounts receivable process includes:
monitoring invoice payments
matching payments with invoices (also known as invoice reconciliation)
Some people refer to accounts receivable as bills receivable, while others call it invoicing.
Accounts receivable vs. accounts payable
Accounts receivable (AR) refers to the money owed to a business for goods or services but not yet received. While companies wait for invoices to be paid, they are listed on the balance sheet as an asset.
Accounts payable (AP) is the opposite of accounts receivable - it's how much money a company owes other businesses. Accounts receivable are listed as assets, whereas accounts payable are listed as current liabilities.
How does the accounts receivable process work?
The accounts receivable process flow is fairly straightforward.
You could say the process begins when you agree on terms with a client in your purchase agreement. But essentially, there are five main steps in the process:
Deliver the goods or services to your customer.
Send the invoice to the customer immediately.
Enter the invoiced amount as an account receivable.
Monitor the invoice regularly, and if payment hasn’t arrived, send reminders to the customer. If the customer still fails to pay, issue another invoice with any additional penalties as agreed.
Mark the invoice as “paid” and enter it into the accounts receivable ledger when you receive payment.
Note: Late fees of 1-1.5% are common, but individual states and countries have different limits for the chargeable interest and fees.
How do you record accounts receivable?
You record accounts receivable as a current asset on the balance sheet and include them on the income statement as a sale or revenue, in the same way as goods or services that get paid immediately.
Some accounting software solutions automatically compute accounts receivable as you create a client invoice.
In accrual accounting, funds that have been earned but not collected – that is, accounts receivable – are classed as accruals. In cash accounting, funds are not recorded until the client pays the invoice.
What are common accounts receivable payment terms?
Accounts receivable payment terms refer to the agreed date by which the customer must pay an invoice.
Net30 is the most common payment term, which means the customer must pay the invoice in full within 30 days. Payment terms can range from a few days up to a full year. However, some large businesses insist on Net60 or even Net90 terms.
Longer payment terms can put a strain on small suppliers if they depend on that money to cover overheads and other expenses. That's why cashflow management – the ability to control how much money is coming in or going out - is a huge factor in whether or not a company succeeds.
What is accounts receivable financing (or invoice factoring)?
Accounts receivable financing is a type of business funding secured against the value of outstanding invoices. It helps businesses, especially small suppliers, manage cashflow problems caused by late-paying customers or extended payment terms.
The invoice value is locked up in accounts receivable until the customer pays. But accounts receivable financing allows the supplier to unlock the outstanding invoice’s value and get paid faster.
Unlike a traditional bank loan, accounts receivable finance providers are interested in the debtor’s creditworthiness, the invoice’s age, and the sum owed. They’re not interested in old invoices, so you can’t use them to get rid of bad debts. Nevertheless, you don’t need to use any property as collateral, and you can secure funding much faster than traditional financing methods.
Finance companies may pay you up to 90% of the invoice value immediately and the remaining amount when the customer settles the invoice. But you won't get the total value of the invoice because finance companies charge fees. You can still use the funds to manage your cashflow, cover operational expenses, and purchase new inventory and raw materials to meet new orders.
What is the ageing of accounts receivable?
The ageing of accounts receivable is a financial management technique used to evaluate the accounts receivable of a company and ensures more efficient debtor management and payment collection.
Typically, suppliers provide goods and services to other companies on payment terms of 30-120 days, depending on the terms of the agreement. As soon as the due date has passed and the customer hasn't paid, the invoice becomes “aged”, meaning it ages by the number of days since it was due. For example, If it was due four days ago, you give it an age of four days.
The ageing method organises receivables based on when an invoice has been issued, when it is due to be paid, and the number of days it is overdue. It helps you to determine which customers to send to collections and who should receive follow-up invoices.
The ageing of accounts receivable is usually detailed in an ageing report, which shows each invoice by date and number. You can use this information to make accurate cashflow predictions and avoid increasing payment terms with customers with poor payment histories.
What is the purpose of an ageing report?
An ageing report is an essential tool for managing your accounts receivable as it shows you how much money is owed to your business at any given time. It highlights:
how much each customer owes you
how long each customer has owed you
which customers owe the most
You can use this information to help you prioritise which accounts to target first. In general, the longer an invoice remains unpaid, the less likely you will receive full payment.
You can also use an ageing report to help you:
Identify credit risks
You can use your ageing report to identify which of your customers poses a significant risk of non-payment. For instance, if a customer owes your business a large sum or has a history of failing to settle their invoices on time, you should consider restricting future credit.
Manage bad debts
You can also use your accounts receivable ageing report to help you manage bad debts. If the recovery of a customer’s debt is no longer possible, you can write it off as bad debt and reduce your taxable income.
Note: You can learn more about bad debt allowances on the Australian Taxation Office website.
Qualify debt factoring
If you apply for accounts receivable financing, the finance company will use your ageing report to identify which sales invoices will qualify for financing. Funding providers typically fund recent invoices issued to clients who have a good credit rating and pay their bills on time.
Improve collection processes
An ageing report that shows a significant number of older outstanding receivables may indicate that you need to improve your collection processes. Most business owners struggle to find the time to chase invoices, with Australian small businesses spending an average of 12 days a year chasing payments.
In summary, ageing reports give you a comprehensive overview of your invoicing and collection processes. You can use them to manage your cashflow effectively, create credit policies, and plan future spending.
What happens if clients don’t pay on receivables?
If clients don’t pay invoices, you should consider writing them off as a “bad debt”.
For instance, a client might have gone bankrupt and is incapable of paying their invoice, or you might be locked in a dispute that’s not likely to be resolved, or they may simply be ignoring your reminders.
Whatever the case, it's lost revenue. And it’s essential to record that in your accounts, especially if you’ve already paid tax on the invoice and you need to claim that tax back. You can do this by writing off the invoice as a bad debt.
Whether you write the invoice off after six months or 18, you can still send invoice reminders. If the client finally pays, you can declare the income on your next tax return.
Is accounts receivable a debit or credit?
When you sell goods or services to a customer without receiving payment, the amount owed to you increases, which means you must debit your accounts receivable. You will also need to credit another account, such as inventory, to show a decrease in goods.
When a customer pays you, the amount of money owed to you decreases, so you must credit your accounts receivable. You will also need to debit your cash account since you have more money.
Are accounts receivable considered assets?
Yes, accounts receivable is money you’re owed, which makes it an asset. When an invoice is paid, it ceases to be an asset and becomes cash in the bank. If it never gets paid, you write off the invoice as a bad debt. And once written off, the invoice is no longer considered an asset.
What is the accounts receivable turnover ratio?
The accounts receivable turnover ratio is the net credit sales divided by the average accounts receivable for a given period.
The accounts receivable turnover ratio determines how effective a company is at extending and collecting credit from its customers. A high turnover rate indicates that a company is more conservative with its credit extension or more aggressive with its collection efforts.
What are the different types of accounts receivable?
There are two main types of receivables: accounts receivables and notes receivables.
accounts receivable are amounts owed to the company for normal credit purchases
notes receivable are amounts owed to the company by customers who have signed formal promissory notes in acknowledgment of their debts
trade receivables are accounts receivable and notes receivable that result from company sales
other types of receivables include interest revenue, wage advances, rents, formal loans to employees, or loans to other companies.
Automate your accounts receivable process
You can automate your accounts receivable process with accounting software like that offered by MYOB.
Small businesses can use customisable templates and automatic invoice tracking to see which clients have paid – and automated payment reminders to nudge those who haven't all within MYOB Business.
Meanwhile, larger enterprises can use MYOB’s Enterprise Resource Planning (ERP) solutions to generate invoices, send statements, verify balances, track commissions, collect and apply payments, and more.