Ep 16 – Accounts Receivable


Episode 016 – Accounts Receivable


Recorded: February 25, 2022

Released: February 25, 2022

Intro by Clive Castle

Sounds by ZapSplat


Accounts receivable are the sales that you generated on account that your customers will pay at a later date. Managing your accounts receivable is crucial to the success of your business as it directly impacts your cash flow. Find the transcript of this episode below.




Hello and welcome back to The Better Bookkeeper Podcast. I am your host, Patrick Donovan, President of Cape May Counting House. Thank you for joining me today. If you would like to see the transcript to today’s episode please visit thebetterbookkeeper.com/016.

The topic of this episode is Accounts Receivable which are the sales for which you have not yet been paid. Poorly managing accounts receivable will inevitably result in cash flow problems down the road. Since every business needs cash inflow, accounts receivable is where we will focus today. I’ll see you on the other side.

Welcome back! If you have listened to previous episodes of this podcast you will notice that I am a big proponent of financial statement analysis. This should become part of your toolbox when it comes to providing value to your boss and/or your client, depending upon your situation. We will be touching on this later in this episode.

Now, let’s start at the beginning. Your boss or client needs to have a clearly defined system for extending credit. Specific criteria should be identified to qualify a customer for credit. You could also use screening services that will pull a credit report (as long as it is for a permissible purpose) and provide you with a summary regarding the creditworthiness of a potential borrow. It may be enticing to offer credit to every customer to boost sales but you must also consider that having loose credit policies will more than likely increase your chances of not getting paid. Each sale on account that does not get paid means you are taking a loss so it may be better to err on the side of caution and don’t implement policies that are too generous. On the flip side, credit policies that are too restrictive will cause you to lose out on a lot of sales. This is more an art than a science but it helps to have a conversation with a potential customer before extending credit, in addition to, a credit application.

While qualifying criteria is important, terms also need to be clear so that a customer knows their obligations to a T. How much credit will you extend, what is the interest rate, how will the monthly payment be calculated, will you set a minimum payment, when will the payment be due each month, what payment options do you offer (such as in-person, mail, on your website, or through your bookkeeping software)? You could even consider setting up an automatic payment plan but you must get this in writing, signed and dated by the customer. Your contract or credit agreement should also spell out any collection efforts should the account default. If there will be additional charges if an account goes to collection, that must be spelled out as well. Setting aside a block of time to go over this so that the customer fully understands and agrees to the terms is crucial.

Internally, there needs to be systems in place for collecting your accounts receivable. You will need to be assertive here, not rude, but assertive. The business has provided goods or services and expects to be paid. If your software allows it, set up email reminders to go out to customers a week or so before their payment is due, the day after the payment was due if it hasn’t been received (of course, change the verbiage you use because now the account is in default), and a few times thereafter in an attempt to cure the delinquency as quickly as possible. If a customer calls, be sure to take copious notes of what transpired, who spoke to whom, etc. This will aid you as you work through bringing the account current.

This takes care of the pre-sale activity. Now, let’s look at what happens after the sale.

So, to start, let’s do some analyzing. One of the key metrics you should be using to gauge the effectiveness of your collection strategy is to calculate your Days Sales Outstanding (or DSO) ratio. It provides you with how many days, on average, it takes you to collect from customers who have purchased on credit. Usually, you would calculate this on a monthly basis so that you can see whether you are improving from one month to the next. You don’t want to wait a year to find out you’re getting worse.

You will need to take some numbers from your financial statements to feed into this equation. The first is your average accounts receivable which you will calculate by adding your accounts receivable balance at the beginning of the period and the balance at the end of the period and dividing by 2. The next number you need will be the total credit sales you had during that same period.

So to calculate your Days Sales Outstanding, take your average accounts receivable for the period and divide it by your credit sales for the period. Then multiply that number by the number of days in that period. Then, compare this to the terms you offer. If your DSO is 38 days but your terms are 10 days, then you have a lot of work to do to remedy this. On the other hand if your terms are 30 days then you’re not too far off but could still use some improvement.

The next calculation will be the Accounts Receivable Turnover ratio. This is similar to Days Sales Outstanding but it looks at your accounts receivable from a different angle. For this, you will take your credit sales for the period and divide by your average accounts receivable for the period. This will give you a scope of your credit sales compared to your average accounts receivable. If this ratio increases from period to period it is telling you that you are making a larger portion of your sales on account compared to the average. The increase in accounts receivable should cause you to put a greater emphasis on reviewing your existing collection procedures because your cash flow can be negatively impacted if you don’t as you will be waiting for more of your sales to be converted to cash.

Now that you have done some analysis, where do you go from here?

At a bare minimum, an accounts receivable aging report should be pulled once a month, preferably, more often so that it doesn’t take a month before the next action is taken. This report will drop each sale into what is called a bucket. You will have one bucket for accounts that are current, one bucket for 0-30 days past due, one for 30-60 days past due, 60-90 days past due, and depending upon your software you may have one for over-90-days past due or 90-120, and then a final one for 120+ plus days past due.

What you need to remember is that the longer an account is past due the more difficult it will be to collect. The more time that has passed, people begin to forget details about the transaction, if there were issues with the product or service, with whom they spoke, and so on. This is why it is so important that you stay on top of your accounts receivable. It may give you a warm and fuzzy feeling that your sales are increasing because you are allowing people to take longer to pay you but if they never pay you then you have only worsened your financial situation.

So, with your accounts receivable aging report you want to focus on the accounts that are 0-30 days past due as this represents the lowest hanging fruit. Those accounts you will have the best chances of collecting but don’t forget the older accounts. Just know that you may be facing some sizable write-offs with accounts older than 90 days but that doesn’t mean you shouldn’t still work them. As you begin to start paying more attention to the accounts receivable you, ideally, want to minimize the chances of an account getting to that stage. It’s going to happen, for sure, but you want to keep that bucket as low as possible.

Any discussion about accounts receivable would not be complete if we didn’t discuss allowance for doubtful accounts and bad debts expense. Every business who sells on credit must face the possibility that some accounts will just not be collected which means there should be some sort of offset to accounts receivable. Otherwise, the accounts receivable balance will not be completely accurate in terms of what will actually be collected. Having this offset will give investors and lenders a bit more insight into the makeup of you’re A/R balance and be used to determine if that balance can really be trusted as an asset.

To use this allowance you would review your accounts receivable balance at the end of the month and make a guestimate of what you think would not be collectable. You would then make an adjusting entry to your books by debiting Bad Debt Expense by that amount and crediting Allowance for Doubtful Accounts by the same amount. In subsequent periods, you would review the accounts receivable balance, determine the amount that may not be collectable and make the adjusting entry to reflect that. Remember, the reason these adjustments are made is to reflect a more accurate amount of what will be collected and these adjustments should be made in the period in which the sales are made, hence why you are reporting an allowance for bad debt.

And that, is that. I hope that you found this episode about accounts receivable helpful and that you will make use of it to provide additional value to your clients.

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