Most small businesses sell to their customers on credit. That is, they deliver the goods and services immediately, send an invoice, then get paid a few weeks later. Businesses keep track of all the money their customers owe them using an account in their books called accounts receivable.
Here we’ll go over how accounts receivable works, how it’s different from accounts payable, and how properly managing your accounts receivable can get you paid faster.
What is accounts receivable?
Accounts receivable is any amount of money your customers owe you for goods or services they purchased from you in the past. This money is typically collected after a few weeks and is recorded as an asset on your company’s balance sheet. You use accounts receivable as part of accrual basis accounting.
Where do I find accounts receivable?
You can find your accounts receivable balance under the ‘current assets’ section on your balance sheet or general ledger. Accounts receivable are classified as an asset because they provide value to your company. (In this case, in the form of a future cash payment.)
Your general ledger will show your total accounts receivable balance, but to dig into outstanding payments by individual customers, you’ll usually need to refer to the accounts receivable subsidiary ledger.
What’s the difference between accounts receivable and accounts payable?
Though lenders and investors consider both of these metrics when assessing the financial health of your business, they’re not the same.
Accounts receivable are an asset account, representing money that your customers owe you.
Accounts payable on the other hand are a liability account, representing money that you owe another business.
Let’s say you send your friend Keith’s business, Keith’s Furniture Inc., an invoice for $500 in exchange for a logo you designed for them.
When Keith gets your invoice, he’ll record it as an accounts payable in his general ledger, because it’s money he has to pay someone else.
You (or your bookkeeper) record it as an account receivable on your end, because it represents money you will receive from someone else.
Does accounts receivable count as revenue?
Accounts receivable is an asset account, not a revenue account. However, under accrual accounting, you record revenue at the same time that you record an account receivable.
For the example above, you’d make the following entry in your books the moment you invoice Keith’s Furniture:
|Accounts Receivable—Keith’s Furniture Inc.||$500||-|
(If you want to understand why we’re making two entries to record one transaction here, check out our guide to double-entry accounting.)
But remember: under cash basis accounting, there are no accounts receivable. Under that system, a transaction doesn’t count as a sale until the money hits your bank account.
What is the “allowance for uncollectible accounts” account?
If you do business long enough, you’ll eventually come across clients who pay late, or not at all. When a client doesn’t pay and we can’t collect their receivables, we call that a bad debt.
Businesses that have been around for a while will often estimate their total bad debts ahead of time to make sure the accounts receivable shown on their financial statements aren’t unrealistically high. They’ll do this by setting up something called an “allowance for uncollectible accounts.”
Let’s say your total sales for the year are expected to be $120,000, and you’ve found that in a typical year, you won’t collect 5% of accounts receivable.
To estimate your bad debts for the year, you could multiply total sales by 5% ($120,000 * 0.05). You’d then credit the resulting amount ($6,000) to “allowance for uncollectible accounts,” and debit “bad debt expense” by the same amount:
|Bad debt expense||$6,000||-|
|Allowance for uncollectible accounts||-||$6,000|
What happens if my clients don’t pay?
When it’s clear that an account receivable won’t get paid, we have to write it off as a bad debt expense.
For example, let’s say that after a few months of waiting, calling him on his cellphone, and talking to his family members, it becomes clear that Keith has disappeared and isn’t going to pay that $500 invoice you sent him.
In this case, you’d debit “allowance for uncollectible accounts” for $500 to decrease it by $500.
Remember that the allowance for uncollectible accounts account is just an estimate of how much you won’t collect from your customers. Once it becomes clear that a specific customer won’t pay, there’s no longer any ambiguity about who won’t pay.
Once you’re done adjusting uncollectible accounts, you’d then credit “accounts receivable—Keith’s Furniture Inc.” by $500, also decreasing it by $500. Because we’ve decided that the invoice you sent Keith is uncollectible, he no longer owes you that $500.
So the resulting journal entry would be:
|Allowance for uncollectible accounts||$500||-|
|Accounts Receivable—Keith’s Furniture Inc.||-||$500|
What if they end up paying me after all?
Let’s say a few more months pass, and a mysterious envelope with no return address appears in your mailbox. It’s a cheque from Keith’s Furniture Inc. for $500—he ended up paying you after all!
To record this transaction, you’d first debit “accounts receivable—Keith’s Furniture Inc.” by $500 again to get the receivable back on your books, and then credit revenue by $500.
|Accounts Receivable—Keith’s Furniture Inc.||$500||-|
Finally, to record the cash payment, you’d debit your “cash” account by $500, and credit “accounts receivable—Keith’s Furniture Inc.” by $500 again to close it out once and for all.
|Accounts Receivable—Keith’s Furniture Inc.||-||$500|
Why is accounts receivable important?
Having lots of customers is great. But if some of them pay late or not at all, they might be hurting your business. Late payments from customers are one of the top reasons why companies get into cash flow or liquidity problems.
When you have a system to manage your working capital, you can stay ahead of issues like these. Calculating your business’s accounts receivable turnover ratio is one of the best ways to keep track of late payments and make sure they aren’t getting out of hand.
What is the accounts receivable turnover ratio?
The accounts receivable turnover ratio is a simple financial calculation that shows you how fast your customers are at paying their bills.
We calculate it by dividing total net sales by average accounts receivable.
Let’s use a fictional company XYZ Inc.’s 2021 financials as an example.
Let’s say that at the beginning of 2021 (Jan 1), XYZ Inc. had total accounts receivable of $2,500. Let’s also say that at the end of 2021 (Dec 31) its total accounts receivable was $1,500. It also had total net sales of exactly $60,000 for 2021.
To get the average accounts receivable for XYZ Inc. for that year, we add the beginning and ending accounts receivable amounts and divide them by two:
$2,500 + $1,500 / 2 = $2,000
To calculate the accounts receivable turnover ratio, we then divide net sales ($60,000) by average accounts receivable ($2,000):
$60,000 / $2,000 = 30
This means XYZ Inc. has an accounts receivable turnover ratio of 30. The higher this ratio is, the faster your customers are paying you.
Thirty is a really good accounts receivable turnover ratio. For comparison, in the fourth quarter of 2021 Apple Inc. had a turnover ratio of 13.2.
To calculate the average sales credit period—the average time that it takes for your customers to pay you—we divide 52 (the number of weeks in one year) by the accounts receivable turnover ratio (30):
52 weeks / 30 = 1.73 weeks
This means that in 2021, it tooks XYZ Inc.’s customers an average of 1.73 weeks to pay their bills. Pretty good!
What is an accounts receivable aging schedule?
Keeping track of exactly who’s behind on which payments can get tricky if you have many different customers. Some businesses will create an accounts receivable aging schedule to solve this problem.
Here’s an example of an accounts receivable aging schedule for the fictional company XYZ Inc.
Accounts Receivable Aging Schedule
XYZ Inc., as of July 22, 2021
|Customer Name||1-30 days||30-60 days||60+ days||Total|
|Keith’s Furniture Inc.||$500||$1,000||$500||$2,000|
|ABC Paint Supply||$1,000||$200||$0||$1,200|
A quick glance at this schedule can tell us who’s on track to pay within 30 days, who’s behind schedule, and who’s really behind.
For example, you can immediately see that Keith’s Furniture Inc. is having problems paying its bills on time. You might want to give them a call and talk to them about getting their payments back on track.
What can I do to make people pay faster?
Following up on late customer payments can be stressful and time-consuming, but tackling the problem early can save you loads of trouble down the road. Here’s how you can encourage customers to pay you on time.
Develop a crystal-clear credit policy
When you’re starved for sales, it can be tempting to loosen up the rules you have in place for extending credit to your customers (also known as your credit policy or credit terms). Don’t. This is a short-term fix, usually causes more problems than it solves, and can take your company down a slippery slope.
Instead, develop crystal-clear guidelines for when you can and cannot extend credit to your customers, and don’t hesitate to enforce them, even if it means turning down a few people in the short term.
Vet new customers, ask for up-front deposits on large orders, and institute interest charges for payments that come in after the due date. When a new customer signs up and sees these payment terms, they’ll understand from the get-go you’re serious about getting paid.
Give customers more ways to pay
If you only offer limited payment options, customers may be more inclined to drag their feet when the invoice due date rolls around. There are costs associated with accepting credit card payments, so be aware of these ahead of time, but allowing customers to pay using their credit cards is usually win-win: you’ll get paid faster and they can rack up points.
Offer a financial incentive
One way to get people to pay you sooner is to make it worth their while. Offering them a discount for paying their invoices early—2% off if you pay within 15 days, for example—can get you paid faster and decrease your customer’s costs. If you don’t already charge a late fee for past due payments, it may be time to consider adding one.
Call them and schedule regular reminders
Simply getting on the phone with a client and reminding them about unpaid invoices can often be enough to get them to pay. Sending email reminders at regular intervals—say, after 15, 30, 45, and 60 days—can also help jog your customers’ memory.
What if they don’t pay?
Let’s say you’ve done all of the above and those outstanding invoices remain unpaid. What now?
Cut late-paying customers off
Many companies will stop delivering services or goods to a customer if they have bills that are more than 120, 90, or even 60 days due. Cutting a customer off in this way can signal that you’re serious about getting paid and that you won’t do business with people who break the rules.
Convert their account receivable into a long-term note
If you have a good relationship with the late-paying customer, you might consider converting their account receivable into a long-term note. In this situation, you replace the account receivable on your books with a loan that is due in more than 12 months and which you charge the customer interest for.
Hire a collection agency
If you can’t contact your customer and are convinced you’ve done everything you can to collect, you can hire someone else to do it for you.
Before deciding whether or not to hire a collector, contact the customer and give them one last chance to make their payment. Collection agencies often take a huge cut of the collectible amount—sometimes as much as 50 percent—and are usually only worth hiring to recover large unpaid bills. Coming to some kind of agreement with the customer is almost always the less time-consuming, less expensive option.
When to call something ‘bad debt’
If the costs of collecting the debt start approaching the total value of the debt itself, it might be time to start thinking about writing the debt off as bad debt—that is, debt that is no longer of value to you. Bad debt can also result from a customer going bankrupt and being financially incapable of paying back their debts.
The IRS says that bad debts include “loans to clients and suppliers,” “credit sales to customers,” and “business loan guarantees,” and that a business "deducts its bad debts, in full or in part, from gross income when figuring its taxable income.”
The IRS’s Business Expenses guide provides detailed information about which kinds of bad debt you can write off on your taxes.