Getting Started
What Is Accounts Receivable (AR)? [Definition + 6 Ways to Improve]
Image created with Adobe Firefly
Wouldn’t it be great if all of your customers paid you in cash as soon as they placed an order?
Unfortunately, many businesses don’t work this way.
Instead, we send invoices to our customers with things like “net-30” or “net-60” printed on the top, meaning that we hope our customers pay us within 30 days or 60 days of getting the bill.
And, we all know that doesn’t always happen. Like most businesses, you might have some dead-beat customers and others that just take their time getting payments to you.
This is where accounts receivable comes in.
What is accounts receivable?
Accounts receivable (AR), or receivables, is the amount of money your customers currently owe you for things you have already sold to them. Essentially, it’s a total of all invoices you have given to customers that have not been paid yet.
In your company’s financial statements, accounts receivable is listed on your balance sheet as an asset.
You might also get additional reports from your accounting system (or right in LivePlan’s performance dashboard feature) that tell you the average number of days it takes your customers to pay you—AR days—and which customers owe you and how past due they are.
How to calculate accounts receivable
Calculating your current accounts receivable balance is fairly simple.
- 1.Start with your accounts receivable balance from the previous month (found on your balance sheet).
- 2.Add total sales made on credit (ie. you have not been paid yet).
- 3.Subtract any cash collected from customers for outstanding balances.
Accounts Receivable = Beginning AR Balance + Total Sales on Credit − Cash Collected from Customers
Accounts receivable example
Let’s say at the beginning of the month, your business has a beginning accounts receivable balance of $20,000. That means that customers owe you $20,000 for sales made in previous months.
In that same month, you sell $100,000 worth of products on credit and collect $60,000 in customer payments. The accounts receivable for that month would be:
Accounts Receivable = $20,000 + $100,000 − $60,000 = $60,000
Your business would then have $60,000 in outstanding receivables at the end of the month. This number is also your new starting accounts receivable balance for the following month.
The accounts receivable process explained
The accounts receivable (AR) process for most businesses will include the following after you deliver goods or services:
- 1.Send Invoice: You create and
send an invoice to the customer, detailing the amount owed and payment terms. - 2.Record: The invoice is recorded in your accounting system as an accounts receivable entry. The balance is added to your current accounts receivable total.
- 3.Receive Payment: The customer pays part or all of the balance, which is recorded, and reduces the accounts receivable balance.
- 4.Reconciliation: After each payment (or at the end of each month), compare your current and previous AR reporting to ensure all invoices and payments are accounted for.
The importance of accounts receivable
Tracking your accounts receivable is crucial to managing your cash flow.
While your sales might be going well, if your accounts receivable continue to grow and your customers aren’t paying fast enough, you could end up in a cash crunch.
This is a classic example of why fast growth can actually be challenging for companies. If you aren’t paid fast enough, you will burn through cash and may have trouble fulfilling orders in the future or even paying basic business expenses because you don’t have the cash in the bank.
Tracking accounts receivable is critical to staying on top of the situation so that you can collect the money owed to you.
You should track not only the total accounts receivable number (how much all of your customers combined owe you) but who owes you and which customers are behind on their payments.
With this knowledge, you can decide which customers to chase down for payment and keep your bank account full.
What happens if a customer never pays you?
If some customers never pay you, those accounts receivable will have to be marked down as a “bad debt expense” and deducted from your accounts receivable.
Of course, this should be a last resort, and should only be done if:
- •After a period of time, it’s clear the customer has no intention of paying.
- •You’ve cut off support for this customer.
- •Pursuing payment has become too costly.
- •Alternative terms for partial payment or a payment plan could not be reached.
For more ideas on how to get paid for your goods and services, when a customer isn’t paying you, skip ahead to the end of the article.
Are higher or lower accounts receivable better?
In general, having a lower accounts receivable balance is better. This means that your customers are paying you quickly and that you aren’t owed that much money.
That said, if your company is growing, you may see your accounts receivable balance grow over time as you get more customers and sell more to those customers.
How to use the accounts receivable turnover ratio
To get a sense of how quickly your customers are paying you, you can use the accounts receivable turnover ratio.
This calculation shows how quickly customers are paying you and can be found by dividing your net sales on credit by average accounts receivable over a specific period of time.
Accounts Receivable Turnover Ratio = Sales on Credit / Average Accounts Receivable
Use this ratio to make sure the percentage of accounts receivable compared to your sales remains fairly constant. Ideally, you’ll find that accounts receivable are not increasing faster than your sales as you grow.
Accounts receivable vs. accounts payable
While accounts receivable is money owed to you for products or services that you’ve sold, accounts payable (AP) represents money that you owe to suppliers.
Accounts payable is considered short-term debt, and you need to be able to find a balance between both of these outstanding accounts.
Typically, you’re looking to extend the due date of your own bills (AP) while shortening the time it takes for your customers to pay you (AR). This ensures you have enough cash available to cover your accounts payable and won’t encounter any cash problems.
How to improve your accounts receivable
If you’re having trouble collecting from your customers, or simply need cash to finance growth, you’ll want to improve your accounts receivable.
Here are a few options that will help you collect faster or even borrow money based on what your customers owe you:
1. Offer your customers a discount for paying faster
If you want your customers to pay you faster, you might need to provide an incentive.
3% off for paying within 15 days, as an example.
After all, by letting your customers pay on their own schedule, you’re effectively giving them an interest-free loan. Instead, encourage them to pay faster by offering a discount for early payment.
2. Penalize customers that don’t pay on time
A positive incentive may not work with every customer.
So, instead of offering a discount for early payment, customers that don’t pay on time might need to pay a penalty—usually a percentage of the invoice total.
These penalties can help ensure that customers pay on time and can be part of the payment terms you have them agree to.
3. Offer more ways to pay
Limiting payment options can deter customers from paying on time and in some cases may even cause them to never purchase from you in the first place.
While it does come with additional fees, expanding your payment options to include credit cards or even more niche options like Apple Pay, PayPal, and other digital payment options can get you paid faster.
4. Consider accounts receivable financing
Also known as factoring, accounts receivable financing can be a great way to improve cash flow.
Essentially, once you issue an invoice, you transfer that invoice to a factoring company. They will pay you 80 to 90 percent of the invoice in cash and take over the collections process so you don’t have to wait for your customer to pay you.
Your customer then pays the factoring company who then pays you the remaining portion of the invoice, minus a service fee.
5. Establish a business line of credit
An alternative to factoring is to establish a line of credit for your business. You can draw on this line of credit while you wait to collect payments.
You’ll pay your bank interest for the money that you have borrowed from your line of credit and potentially some additional fees to keep your line of credit open.
However, you won’t have to wait to receive payments before you can pay your own expenses.
6. Use a collection service to collect for you
Instead of spending your time chasing down customers and requesting payment, you can outsource collections for your accounts receivable.
These services don’t loan you any money.
Instead, they reach out to customers and remind them of overdue payments. They often collect a fee for successful payments, so you probably only want to use a service like this with long-term problem customers.
Where to find accounts receivable in LivePlan
There are a few key ways for you to manage and analyze your accounts receivable using LivePlan’s cash flow forecasting and performance dashboard features.
Forecasting accounts receivable
You can forecast accounts receivable for future months within the Cash Flow Assumptions section of the Forecast builder.
Here you can use the “sales on credit” and “days to get paid” sliders to indicate the percentage of sales you believe customers will make with credit and how many days it will take to get paid on average.
If this method of forecasting is too generic for your business, you can forecast accounts receivable assumptions for specific revenue streams instead.
Tracking accounts receivable
As soon as you setup your accounts receivable assumptions in LivePlan, you can see the impact on your cash using the chart at the top of your forecast.
AR will now be listed as a line item in your projected balance sheet and the monthly changes to AR will be included in your cash flow forecast.
As you bring in actual performance data, you can visit your dashboard to review your current accounts receivable balance and compare it to your forecasts as well as previous periods.
Additionally, you can explore the performance of your AR and your average days to get paid by exploring the Trends tab. This takes out the manual processes and calculations required to explore the impact of accounts receivable on your business.
Visit our help center for more details on how to manage accounts receivable and accounts payable with LivePlan.
Track accounts receivable to help manage cash flow
Tracking accounts receivable is a critical component to avoiding cash flow problems.
You’ll want to know how much you’re owed, who owes you, and which customers need to be followed up with to avoid making sales but failing to collect cash.
With the right strategies for managing accounts receivable, you’ll keep a solid cash position which is crucial for any growing company.
However, AR is just one critical metric worth tracking as a business owner.
Check out my write-up explaining the key metrics I recommend tracking (and actively do here at LivePlan) to manage business health, identify potential problems, and ultimately grow your business.
FAQ
Is accounts receivable an asset?
Yes, accounts receivable is considered a current asset because it represents money owed to the business that is expected to be received in the near future.
When a customer pays with a credit card, is that cash or accounts receivable?
Credit card transactions are typically considered cash for the business, as payment is processed and received from a third-party credit card company quickly (typically within 1-3 business days), unlike traditional accounts receivable.
Can you sell someone your accounts receivable?
Yes, businesses can sell their accounts receivable to a third party (a process called factoring) to receive immediate cash, often at a discounted rate.
Noah Parsons
Before joining Palo Alto Software, Noah Parsons was an early Internet marketing and product expert in the Silicon Valley. He joined Yahoo! in 1996 as one of its first 101 employees and become Producer of the Yahoo! Employment property as part of the Yahoo! Classifieds team before leaving to serve as Director of Production at Epinions.com. He is a graduate of Princeton University. Noah devotes most of his free time to his three young sons. In the winter you'll find him giving them lessons on the ski slopes, and in summer they're usually involved in a variety of outdoor pursuits. Noah is currently the COO at Palo Alto Software, makers of the online business plan app LivePlan.
