Accounts receivable are amounts your small business has a right to collect because you sold goods or services on credit to a customer. Customers are at the heart of your small business, making it important that each transaction is a good experience. But if extending credit options to customers sounds risky to you, you’d be right. A recent survey found that 59% of small businesses had to follow up on late payments at least two times, on average. While this doesn’t sound ideal, offering credit options can be a necessary step for staying competitive in your industry.
How Do Businesses Have Accounts Receivable?
As your small business grows and gains more customers, you’ll likely encounter more pressure to offer flexible credit options. These credit options, in turn, create accounts receivable for your small business. You’ll provide the product or service and invoice the client, after which your customer will remit their payment, or receivable.
Many customers prefer using credit because they can make purchases and pay at a later date. Therefore, in order to keep up with your competition, you may need to offer this option in your small business. That being said, restaurants and retail businesses tend to offer credit options less often than other industries.
This means that before you jump into offering credit, you’ll want to take a look at your industry specifically. If you do decide to start offering credit, you’re going to need to consider a few business practices first. These include:
- Your invoicing process. You’re going to want to establish an invoicing process. The goal is to send your invoices out as quickly as possible. The longer you take to send an invoice, the longer you’ll have to wait for your payment.
- Your invoicing software. Invoicing software for your small business isn’t required, but it can help make your payment process more efficient and accurate. You also can use stand-alone systems or mobile apps for invoicing customers effectively. However, some customers still prefer to receive invoices sent by mail or email.
- Your balance sheet. For each receivable that flows into your business, you will need to record it on your balance sheet. Your receivables create assets on your balance sheet.
- Your accounting method. As you offer credit to your customers, you’ll want to look at your current accounting method. Methods include:
- Cash-basis accounting. The timing of transactions in cash-basis accounting is straightforward. In this type of accounting, your revenue is considered revenue when cash is received. In addition, your expenses are considered expenses when cash is paid by you. This type of accounting is popular with sole proprietors and businesses that have no inventory. For cash-basis accounting, you will record no accounts receivable or accounts payable. Typically, cash-basis accounting is for businesses that have less than $25 million in revenue. These businesses often prefer cash-basis accounting because they can receive certain tax benefits.
- Accrual-basis accounting. For this type of accounting, your revenue is considered revenue when the sale is incurred. Similarly, your expenses are considered expenses when the cost is incurred. A sale is considered incurred when your product is shipped or your service is performed. An expense occurs when you order materials or when work by a service provider or employee has been performed. The date of the transaction will be important for accurate accrual-basis accounting.
As you decide which method is better for you, you may want to consult an accountant. Typically, small businesses start with cash-basis accounting and then move toward accrual-basis accounting as they grow.
Also, keep in mind that you can offer credit that will yield accounts receivable in a few other business situations. These include:
- Receivables under long-term contracts. Long-term contracts are used for projects that will take an extended period of time to finish. These can be construction, installation, building, or even manufacturing projects. For long-term contract accounting methods, it’s important not to assume your receivables will be income for your small business. Your receivables involve the cash that is due for the contract. However, the income recognized will depend on the timing of the work that’s being done. Also, small businesses in construction should talk to their accountant about which accounts receivable tracking option is best for their business.
- Receivables from shareholders. Your small business’s shareholders can take a loan from you. When this occurs, it is considered a receivable.
- Receivables from employees. Your employees also can take a loan from your small business. When this occurs, it is considered a receivable, just as with your shareholders or customers.
What’s the Importance of Accounts Receivable?
As a small business, you want your customers to leave feeling happy. In many industries, in order to avoid hassles, and negative customer experiences, you’re going to need to offer credit. This is especially true if your competitors offer credit options.
What Are the Advantages of Maintaining Accounts Receivable?
Accounts receivable can help keep your small business competitive, while offering a number of benefits. These include:
- Building customer loyalty. Allowing your customers to make purchases on credit shows them that you trust them. This trust will help enhance your relationship with customers, which, in turn, can increase future sales.
- Helping you track customer credit easily. As you gather accounts receivable, you also will gather information on the reliability and credit of your customers. This information can help you see how long customers take to pay. It also can help you see which products are frequently bought on credit. Tracking customer credit can allow you to make decisions about whether or not to continue extending credit to certain customers. If a customer has a consistently bad payment history, you may want to stop offering them credit as an option.
- Increasing overall sales. Offering credit to your customers means they don’t need cash in their wallet to make a purchase with you. Customers can be sent an invoice at a later date. This has the potential to increase total sales for your small business. However, reliable customers are at the core of this success. If too many customers fail to pay their invoices, you can easily suffer significant losses.
What Are the Disadvantages of Maintaining Accounts Receivable?
While accounts receivable do offer a variety of benefits to small businesses, there are a few drawbacks to keep in mind as you plan. They are:
- Credit risk. Every time you allow a customer to purchase on credit, there is a risk they will not pay what they owe. As a small business owner, you’re going to want to extend credit only to customers who have a good credit score and have shown reliability in making payments. Otherwise, you may suffer losses from customers who fail to pay.
- The need to follow up frequently. You’re going to need to follow up on outstanding balances with customers. Sometimes, you will have to follow up more than once. This can be time-consuming and requires you to have a follow-up procedure in place.
- Increased transaction costs. Recording, printing, and sending out invoices can have higher costs, compared to just processing cash up front. For instance, you likely will need to invest in software to help in the tracking process.
Accounting for Bad Debt
As a small business owner, you will need to know how to account for bad debt when offering credit options to customers, that is, how potentially uncollectible receivables are valued. Two ways to do this include:
- As a write-off. Once you determine that a customer will not pay what they owe, the amount can be charged directly to—that is, written off as— bad debt expense.
- Allowance method. In this method, when you realize a customer is not going to pay what they owe, the amount is deducted from a predetermined estimate. This estimate is the amount of accounts that you predict will not pay.
What Is the Difference Between Accounts Receivable and Accounts Payable?
Accounts receivable and accounts payable may sound similar to you, but they’re very different. Accounts payable is the opposite of accounts receivable. Instead of customers owing you money, you owe your suppliers money. Accounts payable represent what you buy on credit from suppliers or vendors. These transactions are considered liabilities for your small business.
For example, say you own a computer repair business. When you run out of hardware, you order it from your supplier on credit. This transaction would be processed as an account payable. You will need to pay your supplier in the future for the hardware you have purchased.
Recording Accounts Receivable
Offering a credit option to your customers is only a good idea if you record the transactions properly. This means you’ll want to consider necessary steps for success. These steps include:
- Establishing your credit practices and standards
- Sending invoices to your customers
- Tracking accounts receivable
- Receiving your accounts receivable or payments
Each step for implementing and utilizing accounts receivable can be done in a variety of ways. These include:
- Manual recording. You can always keep your own records by hand. However, keep in mind that there are more efficient ways to record your transactions.
- Using accounting software. You can use internal accounting software to record your accounts receivable. This software can easily generate invoices. You also can get a stand-alone system that focuses only on accounts receivable for your small business. Many small businesses use QuickBooks accounting software. You also can use Patriot accounting software for small businesses, or, to find business accounting software that fits your needs, you can search Capterra’s website.
Also, while documenting your accounts receivable, you will want to pay attention to:
- Deferred income. This involves amounts received by your small business, in advance of earning it. Any payments that your customers make in advance are the opposite of receivables. They’re considered liabilities. You will need to make sure that your open invoices reflect payments made in advance.
- Customer deposits. These involve amounts received by your small business in advance of providing your product or service. Sometimes, customers make deposits that will go toward the cost of building their product. Similar to deferred income, payments made by customers in advance are considered liabilities and the opposite of accounts receivable. They’ll need to be recorded on your open invoices.
- Returned inventory. For returned inventory, you will want to credit your accounts receivable if the item was purchased on credit or through an invoice. For cash, check, or credit card transactions, you would credit your cash account instead of accounts receivable.
Accounts Receivable Aging Report
Accounts receivable can accumulate fast, but don’t worry: Analyzing them won’t be as difficult as it may seem at first. To analyze your accounts receivable, you will want to consult an accounts receivable aging report. This report is standard in most accounts receivable software used for small business accounting.
The report will show unpaid customer invoices in certain date ranges. For example, this could be a 0- to 30-day age bracket, 31- to 60-day age bracket, and older than 60-day age bracket. As you consider the accounts on your report, you’ll want to pay extra attention to:
- Invoice number
- Invoice date and due date
- Customer’s name
- Any collection notes
- Unapplied credits (removing unapplied credits can help you reduce the amount of overdue receivables on your list, which is better for your organization)
You’ll want to address the customers who have been overdue on their payments the longest. From there, you can work your way down the list.
Addressing Overdue Customers
Collecting receivables from overdue customers can be stressful. You’ll want to make sure you address them in the correct ways. These include:
- Making sure your internal records are up to date. Before you follow up with anyone, make sure that your system is accurately telling you which customers are late.
- Considering using software. Your internal accounting software can alert you in advance when a customer is showing the potential of being late.
- Following up with customers who are continually late. Every small business that offers accounts receivable has customers who consistently don’t pay or pay late. You’ll figure out quickly who these customers are and will want to follow up with them. You can start by sending an email and then move to a phone call.
- Avoiding following up too soon. You don’t want to follow up on good, paying customers too soon. This can be upsetting for them and they may feel harassed.
- Using a collection firm as a last resort. This should only be used for customers who have not paid after you have emailed, called, and followed up repeatedly. At this stage, you should be prepared to not receive the payment.
During the payment collection process, stay open to customers’ opinions. If you hear the same complaint over and over, you may be able to improve the customer experience. Sometimes, the problem may even be on your end of the transaction. For example, if your billing department fails to send out invoices in a timely manner, your customer will likely not pay on time. Billing problems can and do happen in businesses of any size.
What Is an Accounts Receivable Turnover Ratio?
Once you understand your accounts receivable aging report, you can take your analysis one step further. To do this, you can explore your small business’s accounts receivable turnover ratio. Although this ratio isn’t commonly used by small businesses, it can be helpful. It will tell you how many times per year a small business collects accounts receivable. From there, you can tell how efficient you are at issuing credit and collecting funds:
Accounts receivable turnover ratio = net credit sales/average accounts receivable
A high accounts receivable turnover ratio can indicate that your small business’s collection process for receivables is efficient. In contrast, a low ratio indicates that your collection process is not efficient.
This ratio indicates efficiency of collection because it tells you how many times, on average, you collect your receivables per year. You can tell if your ratio is good or bad based on your previous year’s ratio and on the average for your industry.
The more carefully you track your accounts receivable, the better. Typically, small businesses calculate their turnover ratio either annually, quarterly, or monthly. The longer it takes you to collect your credit sales, the more likely you will lose money.
Offering accounts receivable can help keep your small business in line with competitors in your industry. It also can build strong customer loyalty, help you track customer debt, and improve the financial organization of your small business. So long as you’re able to handle the potential credit risk, bad debt, and payment follow-ups, accounts receivable may be a good option to consider. And who knows? It may even help improve your small business’s profit margin.