What is accounts receivable and how to manage it

Starting a business is the most exciting thing an entrepreneur can set their mind to. But there are aspects of running a business that aren’t so glamorous. Paying bills, for example. Or keeping track of incoming payments and receipts.

Yet, these tasks are a critical and unavoidable part of running a successful company.

Whether you own a coffee shop or you’re an interior designer, it’s vital to know the basics of accounting. The better you understand how to manage and optimize your business finances, the easier it will be to stay organized and profitable.

In this article, we’ll introduce you to the concept of accounts receivable: what it means and how to manage it.

First, what is accounts receivable?

Accounts receivable (AR) refers to money owed to a business by customers for products or services that have been provided, but not yet paid for. In other words, accounts receivable includes all outstanding or unpaid customer invoices.

So what does accounts receivable mean? Essentially, any payment you expect to receive for goods and services already provided is considered accounts receivable. For example, an electrician installed lighting for a big construction project. They then billed the customer for an amount of $7,500 but have not yet received the payment. The money owed to the electrician is considered a part of the accounts receivable.

Although AR refers to monies that have not yet been paid and are still outstanding, they are listed on the balance sheet under “Assets” as “Current Assets”. Plus, any amount of money owed by customers for purchases made on credit is also considered AR.

Why is accounts receivable important?

Every business aims for profitability, and being profitable means getting paid for the work that you do. No business will thrive if it can’t keep track of customer bills and payments.

Especially for small and medium-sized businesses who may be DIY-ing their accounting and bookkeeping, here are several reasons why AR is so important:

• Cash flow: AR helps you track how much revenue is expected to come in and when. This knowledge is essential to plan properly for day-to-day operational costs and invest wisely in business growth. For example, the electrician wants to buy an expensive tool that could open up a new avenue of business. However, looking at his AR, he doesn’t have a lot of cash expected to come in in the next quarter. So, it’s best to wait a few months to reassess the purchase.
• Customer relationships: Smart AR management enables you to plan your income stream and offer credit terms that will be attractive to potential customers. Also, a smooth accounts receivable process means you can gently remind customers when payments are close to their due date, avoiding potential unpleasantness or conflict.
• Credit management: Tracking accounts receivable allows businesses to assess the creditworthiness of their customers. This way, you can minimize the risk of non-payment and prevent financial losses.
• Liquidity and business growth: AR enables you to properly track and improve the business’s liquidity, so you can more easily secure loans and funding to help your business grow. It also enables extending credit to customers with efficiency and peace of mind, so you can increase sales volume and market reach. 

How does the AR process work?

Depending on a company’s size and volume of invoices, the AR process may differ slightly. For example, not all businesses work with purchase and sales orders. However, the basic steps of the accounts receivable process for every business will look something like this:

Step 1: Purchase order

The AR process starts when a customer places an order for goods or services. Often, they will provide a purchase order (PO), which outlines the details of the future transaction, including items ordered and the agreed price.

Step 2: Sales order

Once the PO is received and approved, the business owner or accounting team issues a sales order (SO) that confirms the sale, the goods/services purchased, the payment amount, the expected delivery date, and other terms and conditions of the sale. 

Step 3: Credit given

The SO is reviewed and approved on credit issued to the customer. The details of the credit are recorded in the account books with the business as the creditor and the customer as the debtor. 

Step 4: Invoice issued

Once the goods/services have been provided, the invoice is issued to the customer. In some cases, an advance or partial payment is requested by the business upfront. In that case, the final invoice after the sale is completed will cover the unpaid portion of the original amount. Either way, invoices must include all payment details, including goods/services provided, payment amount, due date, and the reference number for the purchase order.

Step 5: Collections

The AR team or business owner now collect payments from outstanding invoices. Payments can be received via cash, check, bank transfer, or credit card. Businesses should make it as easy as possible for customers to pay. Some online AR platforms, like Melio, offer businesses the ability to choose how to pay digitally, including bank transfer or credit card while you receive the funds however you prefer. 

Tracking AR enables you to see which payments are getting close to their due date, or are overdue. Then, it’s time to launch into overdue collection processes, whether it be reminder emails, or issuing late payment fees. 

Once the invoice is settled, the amount is deducted from accounts receivable and recorded in the balance sheet as an increase in cash or bank balance.

Accounts receivable vs. accounts payable: What’s the difference?

Accounts receivable and accounts payable are two sides of the same coin. 

AR is the money your business is owed by customers for goods/services you have already provided, while accounts payable (AP) is everything your business owes for goods/services already provided to you. 

That includes all your business expenses such as rent, taxes, utility bills, supplies, and vendor payments.

AR and AP are listed on opposite sides of the balance sheet. How are accounts receivable classified? As Assets, and more specifically, current assets. Accounts payable, on the other hand, is recorded under Liabilities, and specifically under current liabilities.

Let’s take a look at accounts receivable vs. accounts payable, side by side:

The importance of a good AR process

A good, efficient AR process goes hand in hand with healthy finances. One of the best ways to make sure you have such a process in place is by automating it.

Let’s say, for example, you run an organic farm, selling quality vegetables to restaurants across the state. You make a sale and deliver the produce yourself, provide an invoice, and receive a check as payment. However, one of the checks you received bounced. Not only that, but you forgot to update your books with the correct amount and the customer now claims the amount was lower than what you agreed upon. 

Human error is entirely predictable and common, especially in accounting and finance. No matter how much you trust your customers, using an online platform to automate and manage the accounts receivable process will help prevent difficult circumstances like these. If problems do arise, having an accounting tool at your back will make it much easier to resolve with minimal conflict.

There are different tools that allow you to manage all your AR online. Melio, for example, makes it easy to keep track of all your customer invoices, request payments, and receive payments online. Melio eases the AR process from A to Z, by tracking and recording all invoice details for all customers. By connecting your bank account, you get paid directly to your bank account, reducing check handling time and costs. 

Let’s take a look at some extra benefits of digitizing your AR process with a tool like Melio:

More benefits of a digital AR process

Automate your AR process

In this article, we’ve covered the essentials of accounts receivable—what’s AR, how an efficient accounts receivable process contributes to your business’s financial health, and how digital payment platforms can benefit this process. 

Now it’s up to you to implement an online AR process that will improve how you collect outstanding payments, and ensure all the money you are owed actually comes in, on time.