Many business owners don’t realize how vital accounts receivable management is to the health of their business. That’s because accounts receivable (AR) is often thought of as a back-office function when it’s one of the most important aspects of cash flow management.
This article will give you a clear understanding of accounts receivable management and how you can improve it so your business has a healthy cash flow.
What Is Accounts Receivable Management?
Accounts receivable management is the process of tracking and collecting payments from customers who have outstanding invoices. Doing this involves:
- sending invoices
- following up on late fees
- applying any necessary discounts or penalties
Accounts receivable management is a critical part of cash flow management because it directly affects how much cash your business has on hand.
There are a few key metrics that you need to track to manage your accounts receivable effectively.
Accounts Receivable Turnover Ratio
This metric measures how quickly your customers are paying their invoices. A high turnover ratio means that customers are paying their invoices quickly, which is good for cash flow.
To figure out your accounts receivable turnover ratio, just divide your total sales by your average accounts receivable balance. To know if your turnover ratio is good, you need to compare it to industry averages.
Average Days Sales Outstanding
This metric measures how long it takes your customers to pay their invoices. A low number of days sales outstanding is good for cash flow. To calculate your average day’s sales outstanding, divide your accounts receivable balance by your daily sales. If your average day’s outstanding sales are high, your customers take a long time to pay their invoices.
Accounts Receivable Days
This specific metric measures how many days it takes, on average, for customers to pay their invoices. A low accounts receivable days metric is good because it means that customers are paying their invoices quickly. To calculate your accounts receivable days, divide your total accounts receivable by your average daily sales.
Accounts Receivable Collection Ratio
This metric measures how effective you are at collecting payments from customers. To calculate your accounts receivable collection ratio, divide your total collections by your total sales. If you have a high number, you’re effectively collecting payments from customers, while a low number means you need to improve your collections process.
Why Accounts Receivable Management Matters
Accounts receivable is crucial because it directly affects your business’s cash flow. If customers are paying their invoices quickly, you’ll have more cash on hand to invest back into the business or cover other expenses.
On the other hand, if customers take a long time to pay their invoices, it can strain your cash flow. This can lead to missed opportunities or even financial trouble down the road. In addition, effective accounts receivable management can help you build strong relationships with your customers.
When customers pay their invoices on time, it shows that they’re reliable and value their relationship with your business. On the other hand, if customers consistently pay their invoices late, it can damage the relationship. In addition, customers who don’t pay their invoices on time are more likely to default on other payments, such as loans or contracts.
Improving Your Accounts Receivable Management
In addition to tracking metrics, there are a few other best practices you should follow to manage your accounts receivable effectively. Following these tips can improve your cash flow and keep your business healthy.
Send Invoices Immediately
As soon as a sale is made, send an invoice to the customer. The sooner you get the invoice out, the sooner you can start the collections process. And, if you’re using accounting software, you can set up automatic invoice generation so that invoices are sent as soon as a sale is made.
Doing this is crucial because it’s much harder to collect a payment from a customer who is 60 days late on their invoice than it is to collect a payment from a customer who is 30 days late. In addition, sending invoices immediately can help you avoid late fees by giving customers a shorter window to pay their invoices.
Follow Up On Late Payments
If a customer hasn’t paid their invoice by the due date, follow up with them right away. The longer you wait to follow up, the harder it will be to collect the payment. In addition, if you have a late payment policy, make sure to follow it.
Doing this could involve charging interest on late invoices or sending reminders regularly. Some other ways to follow up on lay payments include the following:
- calling the customer
- sending a letter
- sending an email
No matter what method you choose, make sure to document all communication in case you need to take legal action later on.
Consider Offering Discounts
If you’re struggling to collect customer payments, consider offering a discount for early payment. This discount could be a percentage of the total invoice or a flat fee. For example, you could offer a 2% discount for invoices paid within ten days.
By offering a discount, you’re giving customers an incentive to pay their invoices quickly. And, if you’re still having trouble collecting payments, you could increase the discount to 3% or even 4%. While this may seem like a lot, it’s important to remember that you’re still making more money by getting paid sooner.
Offering discounts can significantly improve your accounts receivable management, but you should use this strategy sparingly. If you offer discounts too often, it could erode your profits.
Keep Track of Your Metrics
To effectively manage your accounts receivable, you need to track key metrics, such as those mentioned above. Doing this will give you a better understanding of your collection process and where you can make improvements.
In addition, tracking metrics can help you identify trends over time. For example, if you notice that late payments are increasing, you can take steps to address the issue.
Consider Offering Payment Plans
If a customer has trouble paying their invoice in full, consider offering a payment plan, which could involve breaking the invoice amount into smaller payments over time. For example, if a customer owes you $1,000, you could offer to let them pay $250 per month for four months.
By providing a payment plan, you’re giving the customer a way to pay their invoice without putting a strain on their finances. And, if you’re still having trouble collecting payments, you could consider offering a more extended payment plan.
In addition, when setting up a payment plan, make sure to get the agreement in writing, which will help prevent misunderstandings and make collecting payments easier if the customer defaults on the plan.
Use Accounting Software
Accounting software can help you manage your accounts receivable more effectively. For example, many accounting software programs allow you to track invoices and payments, set up automatic payment reminders, and generate reports, saving you a lot of time and helping you keep up with your accounts receivable.
Some additional features you should look for in accounting software include the following:
- invoice management
- payment tracking
- customer contact information
- automatic payment reminders
When choosing accounting software, pick a program that fits your business needs. For example, if you’re a small business, you may not need all the features that a larger company would need.
Outsource Accounts Receivable Management
If you’re struggling to manage your accounts receivable, you may consider outsourcing the work to a professional. Many companies specialize in accounts receivable management and can handle all aspects of the process for you. This can include sending invoices, following up on late payments, and collecting payments.
When choosing a company to outsource to, do your research. Read online reviews and compare pricing. In addition, make sure to get a contract in writing so you know exactly what services you’re getting and what you’ll be paying for them.
By outsourcing accounts receivable management, you can free up your time to focus on other aspects of your business.
Use a Collections Agency
Finally, if you’re having trouble collecting customer payments, you may consider using a collections agency. A collections agency is a company that specializes in collecting payments from customers.
They will contact the customer and try to negotiate a payment plan. If the customer doesn’t agree to a payment plan, the collections agency will take further action, including filing a lawsuit.
You usually only want to use a collections agency as a last resort because it can be expensive and time-consuming. In addition, using a collections agency could damage your relationship with the customer.
So, what have we learned about accounts receivable management? First and foremost, it’s crucial to your business’s cash flow health. You need a system for tracking payments, communicating with customers, and collecting debts.
Secondly, you must proactively reach out to delinquent customers and work with them to get paid. Finally, ensure you use the right tools and resources to help you manage your AR effectively. If you follow these tips, you’ll be well on your way to having a healthy cash flow.