Imagine an aspiring NASCAR racer. While the way they drive initially would be definitely commendable, there’s no way they can stick to these basics when they make it pro. Their techniques must evolve as they advance, adapting to more complex tracks, fiercer competition, and professional racing dynamics.
Now, consider your accounts receivable (AR). Like that rookie racer, managing your AR any and which way is fundamental initially. But as your business grows, your strategies must evolve and become solid.
Your AR approach will significantly transform from day one to the moment you hit your stride. However, at its core, it comes down to the basics: understanding and fine-tuning your accounts receivable process.
This article will delve into the fundamentals of the AR process, illustrating how it works and why it's crucial for your financial health. We'll explore the common challenges most companies face as they scale, from maintaining cash flow to dealing with delinquent accounts.
You'll also learn critical metrics and strategies to measure and ensure success. Just like our rookie racer must understand to navigate more complex courses, you'll discover how to steer your AR processes through the growth and expansion of your business, ensuring a smooth and prosperous journey ahead.
What is an Accounts Receivable Process?
When customers buy something but have yet to pay, they list it as an accounts receivable (AR) on their balance sheet.
They do this after sending an invoice, either a paper one or an email. The accounts receivable process is about how a company gets back what they are owed.
The process includes everything, from agreeing on mutually acceptable credit terms to payment mode and keeping track of it.
Good accounts receivable management is vital because it helps you get paid before the invoice is too late or turns into a bad debt. This is important for keeping the cash flowing.
Consider this example: A local bookstore sells a set of books to a school on credit. The school agrees to pay the invoice in 30 days. The bookstore records this sale as an accounts receivable because it's money the school owes them but has yet to pay. Over the next few weeks, the bookstore will keep an eye on this account. When the 30 days are up, the school pays the invoice. The bookstore then marks these accounts receivable as paid, completing the process. This way, the bookstore kept track of the money owed to them and got paid without any issues.
Common Accounts Receivable Process Steps
While you’ll find basic renditions of the steps involved in an AR process everywhere online, we’ll deep-dive into what the process actually looks like.
A customer signs up for the product or service. Once both parties agree upon suitable credit terms, it would be through an email commitment or a half-yearly or annual contract. (Some SaaS companies allow self-serve, but since you would receive the payment almost immediately in most cases, we’re not considering this). Details of the company and the POC get sent to an invoicing solution.
After the invoice is sent, finance teams (namely collectors) will manage updates and track progress on invoice collection. The AR manager oversees collectors on their overall AR collections efforts. The payment will likely be made after the agreed date. Once this happens, collectors will randomly choose a list of customers to follow up with through impersonal dunning messages every 3 or 4 days over 30, 60, or 90 days (depending on the agreed credit terms).
In this AR process step, as you may have already guessed (or unfortunately experienced), follow-up efforts receive very little response from the customers. While some of these cases could be because the emails landed in spam, some could be because the customers simply chose to ignore them, did not get enough context to respond, or were incorrectly followed.
To fix this, AR managers would randomly choose invoices that are more than 45 days due, and depending on various factors (ROI impact of the customer, existing relationship, delayed payment frequency, and more), would decide to send them a final message informing them of service cancellation/disruption.
While this is a good idea, most B2B companies perform this step manually (going through the list and sending out the email). What’s worse is that they would track this information on a spreadsheet. They would keep track of (after sending out the email) who has paid, not responded to it, given a promise to pay, etc. They would also take notes here (to indicate exceptions or provide context to anybody else using this sheet).
Instead of altogether canceling service, some companies would switch their customers to the basic plan if they do not get any kind of response from them. This would prevent them from using paid features and functionalities.
It should be noted here that, till this stage, only the collectors are involved in this collection process.
If the situation worsens, the sales or customer success team gets involved. The reason is that, in some cases, these individuals might have better relationships with the customer because they’re involved in the sales close and satisfaction follow-ups.
However, to get them involved, the finance team may send an email to the sales or CS team or reach out to them via Slack ad hoc to get everyone on the same page.
In most cases, the sales and customer success team may not respond to these reach outs because they don’t have context or aren’t accountable for collections. Finance teams would then figure out other process fixes to get everyone on the same page.
But in most cases, they would fail because process fixes don’t work in the long run. The cycle repeats, and while there could be some cash inflow, many other opportunities don’t come to fruition.
Common Accounts Receivable Process Challenges
One of the biggest challenges many companies face in their AR process is the need for real-time visibility across stakeholders, from higher-ups, managers and collections teams. This hinders tracking speed and collections itself.
The problem is, as mentioned above, that most of the tracking happens on a spreadsheet, such as Excel or Google Sheets. While it may seem a steadfast solution, it becomes problematic when there are multiple invoices to track. It becomes time-consuming for teams to track and record account statuses.
Another major challenge is that reporting is only sometimes done in real-time, since data is spread across multiple systems and spreadsheets. Data reconciliation can take a lot of time to provide a high-level overview of the AR process to higher-ups, such as a CFO or a Director of Finance. This means decision-making on critical accounts becomes time-consuming and needs to be clarified.
Business Impact of Poor Real-Time Visibility and Reporting
When there is no real-time visibility, there is no clear indication of where cash flow is stuck and why. It could also cause sour customer situations where they could be denied service when they have actually paid, but this was somehow missed due to the larger mishandling of things.
Miscommunications like these could even give rise to internal tensions between finance and sales or customer success teams (or even within the same teams!).
Recording and tracking disputes always have to be done by keeping all stakeholders on the same page. However, most companies do not do it in a way that everyone involved has context – this means dispute tracking to closure cannot be done quickly; plus, when it’s not possible to check whether a customer has a dispute, is at churn-alert, or has given a promise to pay, it leads to multiple stakeholders conducting repeated follow-ups with the same customer repeatedly. This leads to, you guessed it – a bad customer experience.
Note: Also, customer conversations mostly remain siloed in individual collector inboxes. This makes it hard to provide shared context to stakeholders when they have to carry a conversation forward.
Another current challenge many companies face is that they need to follow up using personalized emails. These emails also go out from a generic email ID (in some cases, a “do not reply” email) instead of an actual one. This automatically translates to low open and click rates. Plus, if any relevant stakeholder has to be tagged, they cannot – the conversation trail cannot be tracked effectively.
Business Impact of Poor Personalization and Dispute Handling
Both ultimately need better customer experience. Every company strives for best-in-class support and high customer success. You should improve the experience for external and internal customers, such as sales and customer success.
Manual account assignment to collectors is cumbersome and prone to immediate failure. Prioritization doesn’t happen by effectively comparing one invoice to another. For example, if there’s an invoice value of $1,000 and another of $100,000, of which both are due, most collection teams may put the same effort into it.
Another massive problem is that the duplicate accounts could get assigned to different collectors at another time. This primarily impacts the customer experience. Even if a customer responds, it would mean that the collector would have to perform tracking and updating manually, which takes a lot of time and effort.
Business Impact of Manual Account Assignment
Manual follow-ups mean you spend lots of time tracking customers. Collectors shouldn’t spend too much time on mundane tasks – instead, they should spend them on meaningful ones. Additionally, lots of time spent here means that your days sales outstanding (DSO) could shoot up.
Plus, all of this diminishes the possibility of timely collections. While some process fixes along the way can work, inefficiencies could only build up over time without proper automation. You shouldn’t spend double or triple the time of effort to collect.
Key Metrics to Track Accounts Receivable Process Efficiency
Measuring the effectiveness of an AR process involves tracking some key metrics.
These provide insights into how efficiently you manage credit and collection debts.
Days Sales Outstanding
Day sales outstanding measures the average number of days you collect payment after a sale. A lower DSO indicates quicker collections, which is preferred as it implies better cash flow.
DSO = (Total Accounts Receivable/Total Credit Sales) × No. of Days
How to Calculate DSO: Divide the total accounts receivable by the total credit sales and multiply the result by the number of days in the period.
Accounts Receivable Turnover Ratio
ARTR measures how many times you can collect your accounts receivable during a period. It's calculated by dividing total credit sales by the average accounts receivable. A higher turnover ratio suggests more efficient credit and collection processes.
AR Turnover Ratio = (Total Credit Sales/Average Accounts Receivable)
How to Calculate Accounts Receivable Turnover Ratio: Divide the total credit sales by the average accounts receivable for the period.
The aging schedule involves categorizing receivables based on the time an invoice has been outstanding. It helps identify which customers are taking longer to pay, potentially indicating issues with credit policies or customer solvency.
Aging Schedule Formula
Categorize each account receivable by the time the invoice has been outstanding.
How to Calculate Aging Schedule: List all outstanding invoices and categorize them by how long they have been unpaid (e.g., 0-30 days, 31-60 days, etc.).
Collection Effectiveness Index (CEI)
CEI measures the effectiveness of the collection efforts over a specific period. It compares the amount of receivables collected to the amount of receivables available for collection. A higher CEI indicates more effective collection strategies.
CEI = (Beginning Receivables + Monthly Credit Sales − Ending Current Receivables) / (Beginning Receivables + Monthly Credit Sales − Ending Total Receivables) × 100
How to Calculate CEI: Add the beginning receivables to the monthly credit sales, subtract the ending total receivables, divide this by the beginning receivables plus monthly credit sales minus ending current receivables, and then multiply by 100.
Bad Debt to Sales Ratio
This ratio compares the amount of bad debt (uncollectible accounts receivable) to total sales. It helps assess credit sales' quality and the credit policies' effectiveness.
Bad Debt to Sales Ratio Formula
Bad Debt to Sales Ratio = (Bad Debt/Total Sales)
How to Calculate Bad Debt to Sales Ratio: Divide the amount of bad debt by the total sales.
Percentage of Credit Sales to Total Sales
This metric helps you understand the proportion of their sales made on credit. A higher percentage indicates a higher risk or a more aggressive credit policy.
Percentage of Credit to Total Sales
Percentage of Credit Sales = (Credit Sales / Total Sales) x 100
How to Calculate Percentage of Credit to Total Sales: Divide credit sales by total sales and multiply by 100 to get the percentage.
Write-Offs as a Percentage of Receivables
This measures the amount of debt written off as uncollectible to the total accounts receivable. It directly indicates the effectiveness of your credit risk management.
Write-Offs Percentage = (Write-Offs / Total Accounts Receivable) × 100
How to Calculate Write-Off Percentage: Divide the amount of debt written off by the total accounts receivable and multiply by 100.
Streamlining your Accounts Receivable Process
You can seamlessly turn your AR process around by making fixes to these five collection areas:
- Real-Time Visibility, and
Inter-stakeholder collaboration between finance, collections, sales, customer success, and legal teams for shared context ensures you are always aware of what accounts to go after. This is crucial, especially when a collector has to handle escalations and disputes. There could also be instances where the customer provides a promise to pay.
Collaboration issues stem from multiple siloed data sources – for example, a collector and a sales rep could maintain the same data on different spreadsheets with different inputs. Disparate data also comes from separate email conversations without the relevant stakeholders in the loop.
An accounts receivable software provides a simple yet powerful fix to this problem by having up-to-date data at any given time, providing the same visibility across all stakeholders involved.
Automation is crucial to optimizing your AR process and can be done seamlessly with AR automation software. At its core, it aims to unburden all stakeholders from mundane tasks so they can focus on collecting faster and more efficiently.
It should start with the basics: automating dunning with accounts receivable software, quickly setting up dunning sequences and strategies – pause, stop, or resume them at any time, depending on the segment your customers fall under, and other crucial parameters.
Next in line is the cash application. How easy would it be to automatically match invoices accurately to all received payments and remittances? With AR automation, you can do more. You can handle short or bulk payments with automated adjustments for tax, bank charges, or discounts.
Automating your receivables can also help capture all your payment information regardless of its format – PDF, XLS, or PNG.
Sending lots of emails daily (manually) can be impossible. The inability to extend your coverage is another challenge as well. Plus, essential dunning emails sent using a generic email ID often get ignored because the customer wouldn’t be compelled to open them.
Encourage your collectors to add a personal touch to every payment or status follow-up. While doing this manually can be difficult, the software makes it super-easy. Accounts receivable software does everything from out-of-the-box templates to related invoice nudges to infuse quick context. You can choose which email ID you want to send from, capture customer responses, and ultimately automate them.
Real-Time Visibility and Insights
A single, comprehensive place where you can get an “all you need to know” about collections is the dream. An automated receivables tool does just that. It’s equipped with intuitive filters to help users quickly navigate and access the specific data they need.
It also provides real-time visibility into crucial AR accounting metrics such as days sales outstanding (DSO), cash flow and ADP (average days to pay), and CEI (collection effectiveness index) trends.
Moreover, an automated receivables system provides AI-powered indicators such as Customer Health Score (that considers account-level factors) and Predicted Pay Date (that considers invoice-level factors) to help your collector preemptively anticipate who will pay on time and who won’t.
Effective AR management is not about persistent follow-ups on unpaid invoices; developing a comprehensive strategy that includes assessing customer creditworthiness, setting clear payment terms, and utilizing technology to streamline processes is essential.
As we've seen, AR management principles bear similarities to navigating a complex and dynamic environment, much like a professional racer on a challenging track. It requires agility, foresight, and continuous adaptation to changing conditions.
By staying proactive and focusing on these critical aspects, you can ensure your journey through the accounts receivable world is as smooth and successful as possible.