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You've delivered your product or service, but the payment is still pending. As days turn into weeks, you start wondering when the cash flow will come in? Many businesses encounter this situation, which is why it's so important to understand the terms related to accounts receivable.
Actually, 60% of businesses say that one of the main causes of cash flow issues is late payments. Businesses run the risk of experiencing irregular cash flow and financial distress if they don't have a solid understanding of AR terms.
Let's take a closer look at some of the key accounts receivable terms every business should understand and how they can impact your financial health.
Accounts receivable refers to the amounts owed by customers for goods or services provided on credit. Since it indicates future cash inflows, it is listed as an asset on the balance sheet.
For instance, if a consumer buys $1,000 worth of products on credit, the $1,000 is recorded as AR and payment is expected within the specified period.
The AR ledger is a detailed record of all outstanding invoices. Businesses can remain on top of what's owed and when, as it tracks all the customer's balances, due dates, and payment statuses.
Example: A ledger might show a $500 debt due in 30 days and a $200 debt due in 60 days, helping the company prioritize follow-up actions.
Payment terms define the timing and conditions under which a customer must pay. Net30, Net60, and early payment discounts are common phrases that have a direct impact on a business's cash flow.
For instance, "Net30" indicates that payment is due 30 days following the invoice date. "2/10 Net30" offers a 2% discount if the customer pays within 10 days.
Businesses can detect past-due accounts and prioritize collection efforts by using the AR aging report, which arranges outstanding invoices according to the amount of time they have been past due. This report provides a clear overview of which accounts require immediate attention and which are within the payment terms.
Example: A typical AR aging report would indicate that $1,000 is due in 30 days, $500 is past due in 60 days, and $200 is past due in 90 days. This enables organizations to prioritize the most past-due payments first.
Check out our article on the Top Accounts Receivable KPIs and Metrics to Track to learn more about optimizing your AR process.
Days Sales Outstanding (DSO) calculates the average number of days it takes for a company to collect payment after making a sale. Better collection efficiency is indicated by a lower DSO, which enhances cash flow and financial stability.
Formula:
Example:
If a company has $500,000 in credit sales for the year and an average accounts receivable balance of $50,000, the DSO calculation for a 365-day year would be:
This means the company, on average, takes 36.5 days to collect payment after a sale.
The Accounts Receivable Turnover Ratio measures how efficiently a business collects its average accounts receivable within a year. A greater ratio suggests that a business is more successful at turning its receivables into cash.
Formula:
Example:
If a company has $500,000 in net credit sales for the year and an average accounts receivable balance of $50,000, the AR turnover ratio would be:
This means the company collects its receivables 10 times a year, which suggests efficient collection practices.
The cash conversion cycle (CCC) measures the time it takes for a business to convert its investments in inventory and receivables into cash flow. Faster liquidity and improved cash flow management are indicated by a shorter cycle, which enables companies to reinvest their funds more quickly.
Example: If a company takes 30 days to sell inventory and another 30 days to collect receivables, the cash conversion cycle would be 60 days.
The allowance method involves estimating uncollectible debts in advance and recording them as an expense. This technique lowers the AR balance by establishing an allowance for questionable accounts.
The direct write-off method recognizes bad debts only when a specific account is determined to be uncollectible. When the business determines that the client is unable to pay, this method writes off the receivable.
Allowance Method Formula:
This method requires a business to estimate the percentage of AR that will not be collected, based on historical data or industry standards.
Direct Write-Off Method Formula:
This method only records bad debt when a specific account is identified as uncollectible.
Example:
Allowance Method: A company has $100,000 in accounts receivable. Based on its historical data, the company estimates that 5% will be uncollectible. Using the formula:
The company sets aside $5,000 as an allowance for doubtful accounts.
Direct Write-Off Method: If a customer owes $1,000 and the company later determines the customer will not pay, the company writes off the amount:
The company writes off the $1,000 once it confirms the non-payment.
Bad debt is the term used to describe sums owed by clients that are considered uncollectible, usually as a result of the client's bankruptcy, insolvency, or nonpayment. It often gets written off as a cost and constitutes a loss for the company.
Example: If a customer files for bankruptcy and is unable to pay a $500 invoice, the company considers this amount as bad debt, which will need to be written off from the accounts receivable balance.
Risk management in AR involves evaluating the creditworthiness of customers before extending credit and establishing policies to minimize the likelihood of non-payment. Businesses can avoid bad debt and keep a healthy cash flow by proactively managing credit risk.
Example: A company may run a credit check before offering a $1,000 credit line to ensure the customer is capable of paying within the agreed terms.
Accounts receivable outsourcing involves hiring a third-party service provider to handle the AR process, including collections and follow-ups. This improves cash flow and streamlines collections while allowing businesses to concentrate on their core operations.
You can outsource AR management with South East Client Services (SECS) to enhance your collection process, reduce overhead, and optimize cash flow without burdening internal resources. To learn more, consider exploring SECS' tailored AR services.
On the balance sheet, accounts receivable are listed as a current asset, representing amounts owed by customers. Since it shows the possibility of future cash inflows, it is essential for evaluating a company's liquidity and financial status.
Example: A business with $50,000 in accounts receivable will report this as an asset on its balance sheet. This contributes to the company's net working capital, which is calculated as:
Net Working Capital = Current Assets - Current Liabilities
For example, if the business has $100,000 in current assets (including $50,000 in AR) and $40,000 in current liabilities, the net working capital would be:
This means the business has $60,000 in liquid assets available to cover its short-term obligations, with $50,000 coming from accounts receivable.
Knowing how accounts receivable affects the balance sheet makes it easy to see how mastering the accounts receivable terms is crucial to long-term business success.
Managing accounts receivable terms effectively ensures timely payments, enhances cash flow, and helps businesses maintain financial health. By understanding AR metrics like DSO, turnover ratios, and aging reports, businesses can streamline their collection processes and minimize financial risk.
In addition to debt recovery, South East Client Services (SECS) offers a range of services, including flexible payment terms, portfolio management, and compliance-driven solutions. Their comprehensive strategy aids companies in effectively managing receivables and streamlining financial operations.
Ready to enhance your AR management and overall financial strategy? Reach out to SECS today and discover how their tailored solutions can help drive your success!
