What is an accounts receivable?
Accounts receivable represent amounts owed to a business by its customers for goods or services provided. For instance, if you manufacture shoes and sell a hundred pairs to a store on invoice with deferred payment, that invoice becomes an accounts receivable in your accounting until the client settles the bill.
At this point, it's worth noting that the term "debtor" often refers to the client who owes the amount on the invoice, while the "creditor" is the business awaiting payment.
Accounts Receivable in Accounting
Accounts receivable play a pivotal role in accounting. They are recorded as assets on the balance sheet, specifically under "Financial Fixed Assets."
When a business delivers a good or provides a service, account 411 is immediately debited. Simultaneously, account 70 is credited to reflect this transaction.
If the client surpasses the payment deadline without settling their debt, accounting entries need adjustments. In such a case, account 411 is credited, and account 416, dedicated to payment delays, is debited. This ensures the accounting accurately mirrors the business's financial situation concerning its customers.
How to effectively manage accounts receivable?
Effectively managing accounts receivable is vital for a business's financial health. It essentially involves monitoring and controlling client payment periods to maintain healthy cash flow and minimize default risks.
A key element in accounts receivable management is mastering the Working Capital Requirement (WCR). WCR represents the amount of money needed by a company to finance its operating cycle, i.e., the period from when the business invests money to produce and sell goods or services until it receives client payment. A high WCR indicates significant funds tied up in the operating cycle, possibly leading to cash flow issues. Effective accounts receivable management can help reduce the WCR, speeding up receivables recovery and minimizing payment delays.
An Objective: Master the WCR
A pivotal factor in managing accounts receivable is the mastery of Working Capital Requirement (WCR). As earlier described, it's the money needed to fund the operating cycle. Efficient accounts receivable management can help reduce the WCR, aiding faster receivables recovery and minimizing late payments.
Set Clear Credit Policies
Good accounts receivable management begins with establishing clear credit policies. These policies should define credit terms, credit limits, and recovery procedures for each client.
Implement an Accounts Receivable Management Tool
Accounts receivable management tools can simplify this process immensely. Modern software solutions can help track invoices, set automatic reminders for late payments, and even analyze client payment behavior to identify potential trends and risks.
Various Types of Accounts Receivable
Several terms describe different accounts receivable stages. A good grasp of these terms can assist in better managing the receivable life cycle and making informed decisions. Here are some commonly used terms:
- Initial Receivable: When the corresponding invoice isn't due yet because the service or product delivery isn't entirely complete.
- Confirmed Receivable: Considered "confirmed" when its existence is undeniably established by documents such as a signed quote, an order form, validated delivery note, or correspondence confirming the transaction.
- Doubtful Receivable: When the client company faces financial hardships, making partial or full invoice recovery unlikely.
- Contested Receivable: Deemed "contested" if the client disputes the service or product delivery and, as a result, refuses to pay the bill.
- Due Receivable: Becomes "due" once the invoice's payment deadline is reached.
- Liquid Receivable: Called "liquid" when all necessary evaluation elements, like amount and currency, are present on the invoice.
- Aged Receivable: Refers to an overdue unpaid invoice. After a certain period, usually two years, the receivable becomes statute-barred, preventing legal recovery.
Key Performance Indicators (KPIs) for Accounts Receivable
To optimize accounts receivable management, monitoring key performance indicators is essential. Crucial KPIs include the average recovery period for receivables (Days Sales Outstanding or DSO) and the default rate.
- DSO (Days Sales Outstanding): Measures the average time needed to recover an accounts receivable once a sale is made. A shorter DSO is generally better, indicating faster money recovery.
- Default Rate: The percentage of invoices that remain unpaid after a certain period. A high rate may indicate problems in credit policies or the recovery process.
Recovering Accounts Receivable
Before discussing recovery, let's first touch on "reminders." Reminders are essential actions to encourage the debtor to settle their debt. This could be done amicably, like a phone call or reminder email, before advancing to more formal measures.
Despite best accounts receivable management practices, some invoices inevitably remain unpaid. In these situations, businesses must proceed to accounts receivable recovery. This delicate process aims to retrieve due funds without damaging client relationships.
Recovery typically starts with friendly reminders via mail or email, highlighting the client's payment delay. If ineffective, the company might resort to formal measures like sending a formal notice.
If the client remains unresponsive or refuses payment, involving a collection agency or lawyer might be necessary. In some cases, initiating legal proceedings to recover the debt is the only option. However, these measures should be the last resort, as they can strain client relations and incur additional costs.
Best Practices for Accounts Receivable Recovery
Best practices include a clear, consistent process from the first day of payment delay. This could involve automatic reminders, phone calls, and possibly formal notices.
Open communication with clients is also beneficial. If a client faces financial challenges, negotiating arrangements like staggered payment plans could be mutually beneficial.
Documenting all communications and actions during accounts receivable recovery is crucial. Such documentation could be vital if legal proceedings are needed.
Lastly, contracts should always specify clear clauses about bill payments, including the amount, due date, and late payment consequences. Including a clause allowing the company to recover legal fees in case of disputes can encourage timely payments and avoid recovery costs.
Accounts receivable are a core aspect of business financial health. Proper management and efficient recovery processes ensure smooth cash flows, minimize defaults, and sustain profitable client relationships. By mastering the WCR, utilizing management tools, and adhering to best recovery practices, businesses can harness the power of effective accounts receivable management.