What Is The Accounts Receivable (AR) Process? Step By Step Guide

The Accounts receivable (AR) process involves a series of steps that handle the money owed to a business for the purchase and delivery of goods or services. While the principle of AR might seem straightforward, the reality is that it can be complex and challenging. AR provides the critical link between making the sale and receiving payment, essentially serving as an IOU to your business. This blog thoroughly explores the Accounts receivable process, including its steps, key performance indicators (KPIs), common challenges, and the benefits of AR automation.

The Importance of Accounts Receivable

Accounts receivable are crucial assets on your balance sheet, representing the outstanding invoices that your customers owe you. Efficiently converting these receivables into cash is vital for maintaining positive cash flow. The AR process involves several key activities: invoicing, collections, payment processing, and posting payments. Let's explore the details by examining the eight steps in the accounts receivable turnover ratio process. 

1.      Receive Order

The AR process begins when a customer sends a purchase order (PO) expressing their intent to buy your goods or services. Once the PO is approved, a sales order is created. This document details the goods or services being sold, the quantity and price of the items, and other terms of the sale, such as discounts, delivery date, and location.

2.    Approve Credit

Assessing the customer's creditworthiness is a critical step to reducing exposure to bad debt. The accounts receivable turnover ratio process can vary depending on whether the customer is new or existing. The goal is to determine whether to approve or deny credit or arrange alternative payment terms. Effective credit approval minimizes the risk of nonpayment and ensures that your business deals with reliable customers. 

3.    Send Invoices

An invoice serves as a definitive record of the purchase, detailing the amount due, the payment due date, and other considerations like late payment fees and discounts. Invoices are typically delivered to the customer via email, electronic data interchange (EDI), or regular mail. Clear and accurate invoicing is essential to prompt payment and avoid disputes.

4.    Manage Collections

Collections are often one of the most challenging aspects of AR. It ensures the invoice is error-free, sent to the customer, and followed up for payment. The accounts receivable turnover ratio process generally follows a structured approach:

·         7 days past due: Send a gentle reminder.

·         814 days past due: Follow up with a second contact.

·         1530 days past due: Send a dunning letter and potentially apply late fees.

·         3145 days past due: Make a fourth contact and send a final letter.

·         4660 days past due: Continue outreach at a predetermined frequency.

·         6190 days past due: Engage senior management, legal counsel, or a collection agency for significant amounts.

5.    Address Disputes

Disputes can arise for various reasons, such as errors in the invoice, issues with the goods or services provided, or discrepancies between the proposal and the invoice. When a dispute occurs, the customer may make a short payment, which adds complexity for the AR team. Resolving disputes promptly is essential to maintain good customer relationships and ensure cash flow.

6.    Write off Uncollectible Debt

If all efforts to collect payment have been exhausted, the debt may be deemed uncollectible. This decision varies by industry and company financial policies. Writing off bad debt is necessary to clear the receivables ledger and reflect an accurate financial position.

7.    Process Payments

Efficient payment processing is vital for accurate financial records. Popular payment methods include ACH or EFT, wire transfer, debit, credit, or virtual cards, and checks. Companies must have the right tools to support various payment methods, such as payment gateways, merchant accounts, eCommerce platforms, or lockboxes for check payments. Once a payment is received, it is posted to the corresponding invoice, and the transaction is recorded in the AR ledger.

8.    Handle Reporting

During the month-end close process, the finance team reviews all recorded transactions and transfers the closing balance of all general ledger accounts into a trial balance report. This step is crucial for creating accurate financial statements and assessing AR effectiveness. Regularly reviewing AR status helps the finance team reach KPI metrics such as days sales outstanding (DSO), collection effectiveness index, and staff productivity.

AR Key Performance Indicators (KPIs)

Monitoring KPIs is essential for evaluating the efficiency and effectiveness of your AR process. Some critical AR KPIs include:

·         Days Sales Outstanding (DSO): Measures the average days to collect payment after a sale.

·         Collection Effectiveness Index (CEI): Evaluates the effectiveness of the collections process.

·         Staff Productivity: Assesses the efficiency of the AR team in managing invoices and collections.

Common Challenges in Accounts Receivable

The accounts receivable turnover ratio process is not without its challenges. Common issues include:

·         Delayed Payments: Late payments can disrupt cash flow and impact financial stability.

·         Disputed Invoices: Resolving disputes takes time and can delay payment.

·         Credit Risk: Extending credit to unreliable customers increases the risk of bad debt.

·         Manual Processes: Manual invoicing and payment processing are time-consuming and prone to errors.

Benefits of AR Automation

Automating the AR process can address many of these challenges. Benefits of AR automation include:

·         Faster Invoicing: Automated systems can generate and send invoices quickly, reducing delays.

·         Improved Accuracy: Automation minimizes errors in invoicing and payment processing.

·         Enhanced Collections: Automated reminders and follow-ups can improve collections efficiency.

·         Better Reporting: Automated systems provide real-time AR status and KPIs insights.

Conclusion

Understanding and optimizing the accounts receivable turnover ratio process is critical for maintaining positive cash flow and financial stability. By following the eight steps outlined in this blog and leveraging automation, businesses can improve the efficiency and effectiveness of their AR process, reduce the risk of bad debt, and ensure timely payment. Regularly monitoring AR KPIs and addressing common challenges will help your finance team achieve its goals and support the overall health of your business. For further detail, visit https://aquifercfo.com/