Accounts receivable refers generally to money a business is owed for products or services that have been delivered or provided to customers. It is a crucial part of operations for many businesses, due to custom or routine in certain industries, where requiring immediate payment on delivery is unnecessary or could cause delays that strain a customer’s ability to run its business. If, however, the amount due increases to a figure that is unsustainable for the business that is owed, it can cause serious cash flow problems and ultimately impacts its profit.
Understanding how accounts receivable fits into your business is a basic, but important component of success, especially for smaller businesses or those that might not have excess cash to fund obligations while waiting for payment in full. Here are some key concepts relating to accounts receivable, and how they impact businesses.
Understanding the basics of accounts receivables
Some businesses might typically have low to zero in receivables, such as a restaurant where customers pay in full at the conclusion of their meals. In simplified accounting terms, these are cash basis transactions and represent the way most modern personal transactions transpire – a customer wants to purchase something so they pay cash upon delivery. This payment doesn’t necessarily have to be made in physical cash to be “cash basis,” as a check, credit or debit card transaction is, for the most part, the same as cash for a receiving business.
Often, however, business to business or B2B sales requires flexibility. Let’s stick with the dining example, but focus on the relationship between a food-service supplier and a restaurant. It is common for suppliers to have arrangements with the various accounts they service to enable quick and efficient delivery, with payment of the amount due not required upon delivery, but instead at some later date. 30 days is a common term for these transactions, which are called “on account” instead of on a cash basis. In this example, the supplier makes the delivery with the understanding that the restaurant will pay its bill in full within 30 days.
Why businesses permit “on account” transactions
At first glance, you might wonder why a business would give goods or services to a buyer without obtaining immediate payment. The restaurant supplier example illustrates a particular industry custom and the reality that many businesses might not have employees walking around with checks at the ready. Also, accounts receivable are more common in businesses that provide services. A business lawyer, for example, might provide advice or review contracts for another business and submit a bill when the legal matter is complete, or periodically, such as with a monthly invoice.
While we introduced the concept of accounts receivable with a B2B example, consumer transactions can involve accounts receivable too. Take, for instance, a lawn mowing service. It’s common practice for a landscaping company to provide service to customers when they are not home. Requiring immediate payment can cause many complications — the landscaper would either have to arrange to be paid in advance or mow the lawns only while the customer is home. The common thread between the B2B and consumer examples is the existence of an ongoing relationship between the parties.
Avoiding out-of-control accounts receivable
While providing goods and services on account for both B2B and consumer transactions It’s easy to see how accounts receivable can get out of hand if not managed properly. Accounts receivable are recorded as assets for accounting purposes. They are like cash but not as liquid, so they only positively affect cash flow when the account receivable is cleared through payment. Businesses must balance the sales and service value of catering to clients’ desire to pay on account with maintaining healthy cash flow for their business. There are several ways for a business to walk this line.
- Protect your business from lean times. The first is having sufficient cash reserves to support your business model, including the delayed payments from your industry’s standard accounts receivable practices. If the standard is a 30-day window, you must have enough positive cash flow to support operations and restocking new inventory without immediate payment. This is one of the main reasons under-capitalized businesses fail.
- If the sale is on credit, get the interest you are due. The next way to control accounts receivable is understanding the difference between “on account” and “on credit.” While the two terms may often be used interchangeably, “on credit” refers to the existence of a promissory note between the parties, and is used when a longer period than the standard “on account” period is necessary. If a customer needs more than 30 days, for example, you should protect their legal and financial interests with a promissory note, where a longer term is allowed in consideration for interest. Interest payments compensate for the delayed cash from a sale or transaction.
- Underwrite your customers. A final method is to know your customers. Understand the pressures in their industry, and get a sense of their cash flow. Although you are not technically a lender when allowing customers to order on account, you can underwrite the ability to pay and better protect your business from late payments and potential loss of profit for nonpayment. This underwriting process should involve discussing fluctuations and keep you out of the dark when it comes to a customer’s potential cash flow problems. The information obtained will inform your accounts receivable policies such as the amount you will allow on account and terms.
- Hire a Collection Agency. A customer who has not paid even after repeated reminders then – “there’s more to this than meets the eye”. There may be other businesses just like yours who are waiting to get paid. If someone has not paid for 90 days, then they will possibly not clear your accounts receivable easily and their financial situation is likely deteriorating with every passing day. Time is of the essence, and taking help from debt collection experts can be quite beneficial. It is safe to start with low cost “Collection Letters” service provided by collection agencies and later switch to more intensive collections service if required.
In an ideal world, businesses would be paid immediately upon delivery, but this does not reflect the reality of doing business in many industries. With some understanding and a few tips, your business can keep cash flow positive and the likelihood of profit greater by leveraging accounts receivable as a tool to facilitate a strong, long-term relationship with your customers.
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