Your Guide to Mastering the Accounts Receivable Process

Last Updated November 20, 2024

The accounts receivable process (AR process) is one of the most important elements of running a profitable business. It is the system a company uses to manage the payments their clients owe them.

Having a streamlined accounts receivable workflow that enables you to collect timely payments from clients is essential to maintaining a healthy cash flow. By understanding what the accounts receivable collection process should look like as well as how you can improve the accounts receivable process, you can set your business up for better financial health.

What Does the Accounts Receivable Process Involve?

The accounts receivable process actually involves several different steps and processes. The following elements are typically found in any accounts receivable workflow process:

• Purchase orders: This is an order submitted by a client for a pending transaction. Approved sales are typically described as sales orders.
• Credit: In the accounts receivable process, purchases are made on credit. Because of this, businesses must have policies in place regarding how to evaluate a client’s creditworthiness and how they extend credit.
• Invoices: An invoice documents all details of a transaction and is sent by the business to the client to describe the goods or services provided, the amount owed, and the payment due date.
• Collections: This is a broad term that describes the methods, systems, and procedures that a business uses to collect unpaid invoices. This may also include working with third-party collections agencies when needed.
• Cash application: This is the process of matching payments to outstanding invoices so that incoming cash can be used to cover a business’s expenses.
• Reporting and analytics: These are the metrics that businesses use to track the effectiveness of their accounts receivable process, with KPIs such as days sales outstanding and collections effectiveness index.

The Accounts Receivable Process: Step by Step

Here’s a closer look at how the accounts receivable process works from start to finish.

1. Customer Places Order

Accounts receivable begins when a customer places an order for a business’s goods or services. This results in a purchase order, which details the pending transaction. In accounts receivable, where credit is used for making purchases, the purchase order must be reviewed and approved before the transaction is confirmed.

2. Approve Credit (If New Customer)

For new customers that don’t have a prior history with the business, the business will typically evaluate the client’s creditworthiness. Whether or not to extend credit depends on the business’s previously established policies and procedures. Careful evaluation of a customer’s creditworthiness helps reduce the risk of defaulted payments.

3. Send Invoice

After the purchase is completed and credit is approved, the business will send a detailed invoice that documents the transaction. The invoice should include the customer’s name and information, details regarding the goods or services they purchased, and payment information, including the payment due date. Invoices may also include details regarding how to submit payment to the business, late fees, and other relevant information.

4. Track and Manage Payment

After the invoice has been sent, the business is responsible for tracking and managing the status of the invoice. Most businesses use an accounts receivable aging report to track how long it has been since a client received an invoice. This allows them to prioritize communications with clients based on the invoice due date and send reminders when a payment is almost due, overdue, and so on.

5. Address Payment Disputes (If Necessary)

Businesses should have established dispute resolution processes to address potential payment disputes with customers. This could include customers disputing the details of an invoice, requesting more time to pay their account balance in full, and other issues. Clear policies for addressing payment disputes will help avoid misunderstandings with clients and ensure the timely collection of invoices.

6. Write Off Uncollectible Debt (If Necessary)

In instances where a client refuses or is unable to pay, businesses may be required to write off uncollectible debt as bad debt. This offsets the total value of their accounts receivable. Businesses may attempt to work with a collections agency to collect the funds or decide to no longer pursue payment.

7. Process Payment

Businesses must have systems in place for collecting and processing payments from their clients. Accounts receivable payment processing options could include ACH, credit card, digital payment tools, or even cash. Offering multiple payment options can help expedite payment from clients. Businesses should clearly communicate how customers can utilize each of the available payment options to fill their invoice.

8. Cash Application

Received payments must be matched to the corresponding outstanding invoice in a process known as cash application. Effective cash application enables the incoming cash to be quickly matched to the corresponding invoice so it can then be put to use by the business to cover its own expenses.

9. Record Transaction for Tracking Purposes and Update AR Aging Report

After the cash application process, the transaction should be recorded in the accounts receivable system. The invoice should be marked as paid in full and updated accordingly on the AR aging report. This way, the accounting team can shift its focus to other unpaid invoices.

10. Verify Invoice at EOM and EOY

Accounts receivable reconciliation should take place at the end of each month and at the end of each year to confirm that invoice data matches payments received. Any discrepancies (including typos or duplicate entries) should be investigated and corrected to ensure accurate recordkeeping.

Common Accounts Receivable Challenges (With Solutions)

There are several common challenges in the accounts receivable process that can make it hard to effectively collect payments and optimize your cash flow. However, by understanding these challenges and implementing key accounts receivable process improvement ideas, you can develop a streamlined workflow that makes accounts receivable much less stressful.

1. Slow-Paying Customers

Depending on the length of your payment terms, customers who are slow to pay could create serious cash flow issues for your business—even if they are paying on time! Slow payments make it harder to cover expenses for your own operations, but shortening your payment terms isn’t always an option. Often, customers are slow to pay due to their own cash flow needs. Figuring out how to collect receivables faster is essential.

Tip: Try Offering Early Payment Discounts. Consider offering an early payment discount (such as 1-2% off the invoice total) for clients who pay a set number of days before the invoice’s due date. This is often sufficient motivation for clients to make payments earlier while helping you get cash sooner.

Tip: Consider Invoice Factoring. Invoice factoring is a process in which you sell unpaid invoices to a factoring company in exchange for a cash advance, typically worth upwards of 90% of the value of the invoice. The factoring company provides the remaining balance of the invoice (minus their service fees) once they collect payment from your client. This helps you get cash in as little as one day.

2. Overdue Invoices

Overdue invoices can be an even more serious problem for your cash flow. Sending clients to collections is generally a last resort, as you don’t want to create a hostile relationship that hurts future business opportunities. However, overdue invoices often run the risk of becoming unpaid invoices, even with frequent outreach from your accounts receivable team.

Tip: Credit Check Your Customers Beforehand. The best way to avoid overdue invoices is to reduce your risk before approving a purchase. Checking the creditworthiness of your customers will help you spot those who are unlikely to pay invoices on time. This way, you can avoid making sales to such customers and save your resources for clients with good credit.

3. Time-Consuming Manual Labor

The accounts receivable process is surprisingly time-consuming. Running credit checks, creating invoices, tracking and updating invoice statuses in your accounts receivable aging report, and processing payments requires a lot of work. And with so much manual data entry involved, there is a high risk of error.

Tip: Work Toward Achieving Full Automation. Implementing automated accounts receivable processing can reduce the risk of human error and save your accounting team valuable time. Using automation to generate invoices or update payment status reports leaves your team more time for client outreach to ensure timely payments.

4. Disorganized or Improper AR Management

The “manual labor” aspect of accounts receivable is often worsened when teams don’t have proper AR management tools. Disorganized systems make it all too easy to lose information or fail to record transactions properly. Even some digital tools such as custom-made spreadsheets can become confusing for multiple people to work with.

Tip: Invest in the Best AR Management Software. Investing in quality accounting software will streamline your team’s work, helping to properly organize records and automate routine tasks. Quality software also makes it easier to share information so everyone is on the same page regarding aging reports, reconciliation, and other essential tasks.

5. Ineffective Communication With Customers

Consistent communication is an important part of ensuring you receive timely payments from clients. Failure to follow up before the due date, on the due date, and when an invoice is overdue can make it surprisingly easy for your invoice to slip through the cracks. However, many accounting teams struggle to know how to manage these communications with customers or even to find the time to write emails in the first place.

Tip: Use Email Templates for Consistent Customer Outreach. Email templates requesting payment can greatly simplify the communications process, giving your accounting team a ready-to-use email that just needs to be filled in with basic information like the customer’s name, invoice number, and amount owed.

Accounts Receivable KPIs for Gauging AR Performance

The following metrics can help you gauge AR performance as you analyze your results:

• Days Sales Outstanding (DSO): This measures how quickly you get paid for your invoices. A low DSO indicates more effective accounts receivable. DSO = (Accounts Receivable / Total Credit Sales) x Number of Days
• Average Days Delinquent (ADD): ADD measures how long it typically takes to settle past-due accounts. ADD = DSO – Best Possible DSO. Best Possible DSO = (Current Accounts Receivable / Total Credit Sales) x Number of Days
• Collections Effectiveness Index (CEI): CEI measures your efficiency at collecting customer payments based on the percentage of accounts receivable collected during a specific timeframe. The CEI should be 80% or better.
• Operational Cost Per Collection: This measures the amount of money your business spends to collect on an invoice. This includes employee time, postage, and so on. The lower the cost, the better.
• Number of Revised Invoices: Invoices may need to be revised due to inaccurate terms, data entry errors, or other issues. This can result in lost time to resolve disputes or to create and deliver revised invoices. Track this to identify invoicing process errors.

In-Summary: The Accounts Receivable Process

The accounts receivable process is multifaceted, requiring careful coordination from the accounting team and clear, consistent communication with customers. By having established practices and procedures for each step of the accounts receivable process, using technology to reduce errors and manual labor, and implementing strategies that ensure timely payment from your customers, you can have confidence that accounts receivable will be a strength for your business.

AR Process FAQs

What is the accounts receivable reconciliation process?

The accounts receivable reconciliation process is an accounting process that compares pending payments from individual clients in the accounts receivable ledger with the company’s overall ledger. This process requires gathering documents and comparing entries to check for data entry errors, duplicate entries, and other mistakes. Any discrepancies must be investigated and corrected to ensure that the general accounts receivable ledger accurately reflects pending customer invoices.

How do you create an accounts receivable aging report?

The accounts receivable aging process is as follows: review all invoices and categorize customers based on your aging schedule (typically based on the date of the invoice or the invoice number). Then, create a list of your customers that have outstanding balances and list them according to the number of days their invoice is outstanding. This helps you see which accounts are the most overdue.

What is accounts receivable turnover ratio and how is it calculated?

Accounts receivable turnover ratio measures your business’s effectiveness at collecting debt. A higher ratio means your business is better at managing credit and accounts receivable.

To calculate your accounts receivable turnover ratio, start by calculating your average accounts receivable. Add the accounts receivable value at the beginning and the end of the period you want to measure and divide the total by two. You’ll also need to calculate your revenue generated by credit sales during the same period.

With this information, you can then calculate accounts receivable turnover ratio with the following formula:

Accounts Receivable Turnover Ratio = Net Credit Sales / Average Accounts Receivable

When is the right time to reach out to a collections agency?

Generally speaking, the U.S. Chamber of Commerce recommends reaching out to a collection agency for invoices that are more than three months overdue.