What is accounts receivable? Examples, process, and tips

What is accounts receivable (AR)?

Accounts receivable (AR) is the money a business expects to collect from customers who have received goods or services but have yet to pay.

For example, when Company A sells products to Company B on credit, Company B owes money, meaning Company A can record the amount owed as accounts receivable (AR). Because AR represents money expected to come in, it’s considered an asset for Company A. On the other hand, for Company B, it’s a liability until the company pays it back and is recorded as accounts payable (AP). AR is listed under the current assets section of a balance sheet in financial statements, as businesses typically anticipate receiving the amount owed within a year.

When customers purchase on credit, the amounts owed are tracked as AR until they’re collected. Properly managing accounts receivables is critical for business cash flow and continued operations.

Examples of accounts receivable

Now that we’ve covered what accounts receivable is and how it’s recorded, let’s examine a simple example to see how AR works in practice.

Say, a law firm completes $10,000 worth of legal work for a new client in September. Instead of being paid back immediately, the firm sends an invoice with net 30 payment terms—meaning the client has 30 days to pay the total amount. On October 1st, the $10,000 the client owes is recorded as an accounts receivable asset on the law firm’s balance sheet and will stay there until the amount owed is made. The journal entries made are:

This entry shows the value of the services that still need to be paid. Until the client pays—by October 31st, in this case—the amount remains as accounts receivable on the firm’s books. Once the amount owed is received, the following journal entries are made:

Here’s how this accounts receivable transaction would appear on a balance sheet, where cash and accounts receivable under assets are affected:

This is just one example of an outstanding invoice, but accounts receivables can also look like the following:

• Credit to customers: Amount owed for goods/services provided on credit
• Rental income: Amount owed by tenants for property rentals
• Interest: Amount owed on loans for interest charges
• Fees: Amount owed for services rendered
• Licensing fees: Amount owed for use of licensed property
• Insurance claims: Amount owed from approved insurance claims

Understanding accounts receivables is just one part of the picture—now, let’s break down the typical workflow for this process.

What is the accounts receivable process?

The accounts receivable process involves several steps to create smooth payment collection and cash flow.

The typical accounts receivable billing process follows these steps:

1. Agree on payment terms: Establish clear payment terms (e.g., net 30) with customers in advance and create an accounts receivable policy outlining when invoices are overdue and when to recognize bad debt. Most companies recognize bad debts after 90 days of delinquencies.
2. Send invoices after a sale or service is provided: Record the invoice in the accounts receivable system or ledger. This establishes the amount owed by the customer.
3. Track payments: Most customers are given 30 days to pay, so accounts receivable staff track what’s owed and follow up with pending payments. This can be automated through your billing process with accounting software.
4. Record payments: When available, record payments to clear the balance on paid invoices. Partial payments are also applied.
5. Manage collections of overdue invoices: If an invoice becomes past-due, accounts receivable will begin collection efforts, including calls and letters to request payment.
6. Lastly, record invoices once payment is received: Invoices are closed out of accounts receivable once fully paid or deemed uncollectible.

Improving the operations of the accounts receivable team and process can significantly impact a business’s financial health. The first step to improvement is understanding how to measure performance.

Critical metrics for assessing accounts receivable performance include:

• Accounts receivable turnover ratio: Measures the frequency at which outstanding receivables are converted into cash over a defined period, offering insight into the efficiency of credit and collections processes. A lower turnover means it takes longer to collect payment from customers.
• Days sales outstanding (DSO): This number reflects the average number of days it takes to collect receivables, providing a key indicator of liquidity and customer payment behavior.
• Cash conversion cycle (CCC): This measures the entire cycle of converting cash into inventory, sales, and ultimately back into money, highlighting the operational efficiency of working capital management.

By observing the receivable balance over time, businesses can improve the accounts receivable process, improve cash flow, and identify trends in customer payments.

We broke down the process—now let’s compare accounts receivable against accounts payable.

Accounts receivable vs. accounts payable

Accounts receivable (AR) and accounts payable (AP) are two critical parts of a company’s financial system, but they represent opposite sides of the same coin.

These are just a few main differences, but you can learn more about the differences between AR and AP here. Furthermore, it's also important to clarify AR's difference with trade receivables covered here.

With AR vs AP covered, it's also essential to understand why properly managing accounts receivable is vital for business success.

Why accounts receivable management is important

With an effective accounts receivable team, AR management not only keeps cash flow steady but also improves financial forecasting by giving you a clearer view of expected payments. But if inefficiencies exist, several problems can occur:

• Delayed collections can strain cash flow and disrupt financial planning
• Operational inefficiencies drain resources and hinder productivity
• Heightened risk of customer defaults, increasing the likelihood of bad debt write-offs

When done right, accounts receivable best practices help you stay on top of what customers owe, reduces the risk of uncollected debts, and keeps your operations running smoothly. Here are some key strategies to help you stay in control:

• Create a clear AR policy: From the start, make sure your customers understand your payment terms and outline when invoices are considered overdue. This sets the stage for timely payments and how to recognize delinquencies, bad debt provisions, and losses.
• Send timely and accurate invoices: Invoices are sent promptly after a sale and include all relevant order and billing details.
• Offer payment options: To make paying convenient, give customers flexibility by accepting various payment methods, such as credit cards, checks, and electronic fund transfers (EFTs).
• Track payments closely: Watch due dates to quickly identify late payments and understand your customers' payment patterns. Automated billing software can help by sending reminders to customers before and after the due date, making follow-up easier and more efficient.
• Follow up on outstanding invoices: Quickly address billing issues or customer inquiries manually or through invoice automation software. Doing so will help you get paid faster and strengthen your client relationships.

These best practices can improve your accounts receivable process and allow your business to stay financially stable.

How to automate bookkeeping with Ramp

Accounting automation is just one part of finance automation. It can get rid of tedious, repetitive accounting tasks and allow accountants to prioritize communication, management, accounting, and strategizing.

Ramp is a solution for finance and accounting teams that does just that. Ramp’s expense management software and corporate card can help you and your team handle your business finances and bookkeeping with best-in-class integrations for more than 30 popular accounting tools, including QuickBooks, Xero, NetSuite, and Sage Intacct.

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