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How to Process Accounts Receivable: A Step-by-Step Guide

Jamie Johnson
Jamie Johnson
business.com Contributing Writer
Nov 17, 2021

Learn why offering credit helps your bottom line and how to manage customer payments.

Most businesses give their customers the option to pay with credit, a process often referred to as “trade credit.” This provides additional flexibility for your customers. If your customers purchase a product or service on credit, you’ll track their pending payment in accounts receivable (AR). 

This article will look at what accounts receivable is, and how your business can track and process its accounts receivable payments. 

What is accounts receivable?

Accounts receivable is the total amount of money owed to your business by its customers. This includes the money already invoiced and any credits or discounts not yet applied to invoices.

A typical AR report shows how much revenue has been generated by invoicing clients for products or services. It can also show how much revenue is outstanding. Accounts receivable is considered an asset since it’s money owed to your business.

For example, let’s say James wants to purchase a $1,200 washing machine, but doesn’t have the cash at the time of sale. The business could grant him a 45-day credit to pay for the item. 

During that time period, the seller would list the $1,200 sale under accounts receivable on their general ledger. Once James pays the debt, the business will mark the transaction as paid. 

Editor’s note: Looking for the right accounting software for your business? Fill out the below questionnaire to have our vendor partners contact you about your needs.

How to process accounts receivable

Processing accounts receivable is fairly straightforward. If you want to offer trade credit to new and existing customers, here are some steps to get started. 

1. Outline the credit terms.

Offering credit to customers can be a risky move, even for a seasoned business owner. To increase your chances of collecting your accounts receivable on time, outline your credit terms. 

By clarifying your credit terms, you’ll be able to evaluate each customer’s credit eligibility before you do business with them. You’ll also set the expectations for your customers from the start. 

Here are some of the terms you’ll want to explain:

  • The amount of credit you’re willing to extend to each customer
  • Your payment terms (for example, Net 30 or Net 60 – the number of days before payment is due)
  • Whether or not your business offers early repayment discounts 
  • Penalties for late payments
  • Other criteria for customer credit 

Once you’ve outlined these parameters, consider the customer’s payment history, cash flow and value as a customer. You may also need to evaluate the terms your competitors offer. 

2. Invoice your customers.

Your business invoicing system can make or break the accounts receivable process. Your invoice is the primary way you’ll communicate with your customers, since it outlines the transaction’s details. 

Every invoice should include the following information:

  • The goods or services sold
  • How much the goods or services cost
  • The name of the customer
  • The payment due date

TipTip: Always review your invoices before sending them, and follow up on pending invoice payments. Most accounting software has features that let you set up automatic payment reminders.

3. Keep track of outstanding payments.

No business owner wants to lose money, but it’s easy to overlook your accounts receivable payments. Failing to stay on top of AR results in a deficit, though, since you’re missing out on those expected payments. 

Tracking your outstanding payments is a crucial part of the accounts receivable process. You may want to create a dedicated accounts receivable ledger highlighting your unpaid invoices and the total amount due. 

A great way to manage your outstanding payments is to use accounting software, such as QuickBooks or Xero, that tracks them for you. You’ll also be able to create an accounts payable aging report to monitor overdue invoices. 

Did you know?Did you know? The best accounting software can do a lot more than just manage overdue invoices. You can use the software to track business transactions, store customer and vendor information, and generate reports during tax season.

4. Collect the payment.

Most businesses offer payment terms between 30 and 60 days, depending on a customer’s relationship with the company. 

Have a process in place for collecting payments, and for ensuring most customers pay on time. The longer it takes your business to collect on overdue payments, the less likely you are to receive the funds. 

Offer customers multiple payment options so it’s easy for them to pay. For instance, you could let them pay by credit card, debit card or ACH. Most companies also offer alternative payment options, like PayPal transactions.

5. Reconcile the payment.

Finally, once the customer has paid their invoice, reconcile the payment. An efficient reconciliation process ensures that your books stay up to date, and that you’re prepared if your business is ever audited. It can also help you avoid costly financial mistakes in the future. 

Again, accounting software is the easiest way to ensure you reconcile these payments, since it gives your business an easy, automated way to track customer payments. 

TipTip: Learn more about top accounting software options in our review of QuickBooks Online, our Xero review and our review of FreshBooks.

What’s the difference between accounts payable and accounts receivable?

Accounts receivable is the money owed to a company for the sale of goods or services. AR is typically listed in a company’s balance sheet as assets and recorded whenever a business offers trade credit to its customers. 

In contrast, accounts payable (AP) shows the amount of money or credit a business owes to its vendors and suppliers. Account payables are usually general expenses, recurring bills and operating costs. While accounts receivable is recorded as an asset, accounts payable is a liability. 

For example, if your company purchases linen material, the business that sold it to you will send you an invoice. Your business owes the money, so you’ll track the bill under your accounts payable section. The other company will record the transaction under their accounts receivable column. 

Accounts receivable and accounts payable are two sides of the same coin, and both play a big role in your business’s cash flow. Both can help you evaluate the financial health of your business at any point in time. 

Why is it important to track accounts receivable?

It’s important to stay on top of your business’s accounts. Let’s look at a few reasons why. 

It improves cash flow.

What would you do if you found yourself unable to pay for your business overhead, payroll or goods received from vendors? AR is a crucial step that turns your invoices into real cash. Failure to track your accounts receivable could cause cash flow problems for your business further down the road. 

It improves cash management.

While sales are essential for any business, a lack of cash on hand will negatively affect your company’s ability to manage its day-to-day operations. As a business owner, you need to convert your accounts receivable faster than your accounts payable. 

This will help you generate better working capital for your business. By tracking your accounts receivable, you can efficiently collect the money owed to your company and maintain positive cash flow. 

It prevents bad debts.

When you let a customer pay on credit, there’s always the chance they won’t pay the money they owe. If enough customers default on their payments, this will affect your company’s profits. 

The longer a customer takes to pay, the less likely it is your business will collect the money. Once a receivable is regarded as uncollectible, it’s written off against your gross profit.

Tracking your business accounts receivable can help identify customers that are overdue on their payments and prevent future bad debts. 

The bottom line on accounts receivable

Offering trade credit is an excellent way to build customer loyalty and increase your profits. Customers who can’t make an upfront payment may be willing to use credit, so it can be one of the best ways to expand your customer base and boost your bottom line. However, offering trade credit means you’ll need to stay on top of your accounts receivable process. Increasing your sales is only helpful if you can collect the money owed to your company.

Establishing credit terms, staying on top of overdue invoices, and quickly reconciling payments is the best way to create a top-notch AR process. Integrating accounting software into your account receivable process can also go a long way in improving your business’s financial health. 

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Jamie Johnson
Jamie Johnson
business.com Contributing Writer
Jamie Johnson is a Kansas City-based freelance writer who writes about finance and business. She has also written for the U.S. Chamber of Commerce, Fox Business and Business Insider. Jamie has written about a variety of B2B topics like finance, business funding options and accounting. She also writes about how businesses can grow through effective social media and email marketing strategies.