Steady cash flow is extremely important for the successful operation of any business. Are you receiving money owed to you by clients on time, and how can your business improve on its accounts receivable processes?
Accounts receivable (AR) is the payment a company gets from its customers for the purchase of goods or services on credit. The company selling the goods or services will determine how long their clients have to pay them for it. The credit period could range from several days to a few months or more.
A company’s accounts payable (AP) is what they owe to suppliers and creditors. This doesn’t include mortgages, payroll, or long-term debt. However, it does include the payments to long-term debt. Imagine that a flour wholesaler sends a baker an invoice for $1,000 for the flour the bakery ordered from them. When the bakery gets the invoice, they will record it in AP because it is money that the bakery owes to someone else. The flour wholesaler will record the $1,000 in AR. This is because it is money they will receive from someone else.
Accounts receivable turnover (ART) is often called the debtor’s turnover ratio. This tells you how effectively your company collects revenue from clients or customers. It indicates how well your company is using its assets long-term.
Many businesses see ART as the defining metric to evaluate the effectiveness of their company’s AR. You can compare your ART ratio with the industry to know how you are doing in relation to the competition.
ART is calculated using the accounts receivable turnover formula. The equation is Accounts Receivable Turnover=Net Credit Sales/Average AR.
For example, let’s say the baker mentioned above has net credit sales of $4 million during the last year. Their average AR is $400,000. They can find the accounts receivable turnover for the past year by dividing net credit sales ($4 million) by average AR ($400,000) to get 10.0. This means that the company’s AR turned over ten times last year.
Three hundred sixty-five days a year, divided by 10, equals 36.5. Their accounts receivable turned once every 36 days during the last year.
The ideal ART ratio for you will vary based on your business. A ratio of 12, meaning you collect once a month, is excellent for a service-based business. But if you are in retail, you want that number to be way higher because you need to collect more often to continue to run your business.
A debit is something you either own or will own in accounting. Credit is something that you owe or a liability. Accounts receivable should always appear as an asset on a balance sheet. Therefore, it is a debit. It is money that a client owes to you.
You will soon have this money in your possession and will be able to benefit from it when it arrives.
Businesses must assess their receivables, especially in light of the COVID-19 pandemic. More companies are becoming insolvent. Supply chains are being interrupted. During times of economic uncertainty, you should assess your receivables frequently. It may be wise to invest in accounts receivable insurance and talk to your accountants and lawyers about an accounts receivable write-off.
An excellent way to evaluate your AR risk is to sort your customers into groups, identify patterns, and establish a risk profile. Next, limit your exposure to bad debts by determining if accounts receivable insurance, credit insurance, transfer of assets, or bonds are right for you. Evaluate your history of unpaid invoices. Pay close attention to your day’s sales outstanding (DSO), and identify future risks to your cash flow.
Making sure that your clients pay you on time can be a full-time job. Accounts receivable software can help you determine if you need to tighten credit or intensify your collection efforts. It applies unique formulas to your receivables collections to help you decide which customers are taking longer to pay and how you can strengthen your policies for extending credit and collecting more vigorously.
Fusion CPA is experienced in handling accounts receivable processes. Our team can help you expertly manage accounts receivable transactions to help you improve turnover, lower your ART ratio, and improve profitability.
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