Accounts Receivable Cycle: A Step-by-Step Guide

The accounts receivable cycle is one of a company's most important business functions. Managing accounts receivable helps companies maintain a healthy cash flow to continue their business operations. 

But finance teams worldwide constantly struggle with timely payments and reducing bad debt, making this process challenging. Manual and paper-based processes also make it difficult to track invoices, which are prone to getting lost in the mail. 

Both accounts payable and accounts receivable are essential functions for managing cash flow for a company. In this blog, we’ll discuss how the accounts receivable cycle works. 

What is accounts receivable? 

Accounts receivable is the money your customers owe you for goods or services purchased on credit. These goods are usually already delivered, but the payment is due later, making it a short-term asset. 

For example, consider your customer purchasing raw materials from you but will pay according to Net-30 payment terms. The payment due in this case will be regarded as accounts receivable till the payment is received. 

What is the accounts receivable cycle?

The entire process, from supplying goods or services to customers on credit to receiving payment, is known as the account receivable cycle. The accounts receivable cycle involves hefty steps to minimize risks pertaining to providing orders to credit and maintaining a healthy cash flow. 

All steps in the process must be carried out carefully and efficiently to avoid incurring losses. Maintaining healthy relationships with your customers while ensuring timely payment can be challenging for accountants to perform. 

Steps in the accounts receivable cycle

The following steps are generally a part of the accounts receivable process

Order placement and credit approval process

The accounts receivable process starts from the customer requesting a purchase from the company. The customer generally does this by sending a purchase order to request the goods or services. If the company accepts the purchase, they generate a sales order to confirm the purchase. A sales order is a legally binding agreement to deliver the order. 

To provide the customer the order on credit, companies must first analyze whether the customer is creditworthy. This is done based on the company’s credit approval policy.The finance team analyzes the customer’s payment history and financial stability to determine whether they can be trusted. Otherwise, other payment methods or terms are suggested. 

Sending invoice to customer

After successful order delivery, an invoice is sent to the customer for payment. Invoices can be sent as an email attachment, uploaded to the customer’s vendor portal or sent via mail. The payment terms stated in the invoice begin once it is received. 

Relaying payment terms and due date

Relaying payment terms and conditions in the invoice to the customer is very important for smooth execution of the accounts receivable process. Ensuring customers adhere to the terms is done by providing a suitable payment policy, or incentivizing them using early payment discounts. Issuing late payment fees can also cause the customer to pay the invoice on time. 

Collection management

Once an invoice has been sent to the customer, the collection management process is carried out. Late payments can be a massive loss to the company. Companies need to set up a collection strategy to help expedite the process. 

Regular follow-ups

Customers might often miss invoice due dates or lose the invoice in their complex approval processes, especially when dealing with manual functions. Regularly following up and reminding the customers can ensure the bill stays at the top of their minds and help you receive payment faster. 

Dispute management

Manual invoicing processes are prone to errors from the company’s or the customer’s end. Therefore, dispute management and redressal are important parts of the company’s accounts receivable process. If an invoice error arises from the seller’s end, a corrected invoice with updated payment due dates must be sent to the customer. Therefore, ensuring the accuracy of invoices and immediate dispute resolution is essential.

Receiving payments or writing debts

If the customer pays the invoice back before the due date, it is immediately accounted for against it. In case the customer doesn’t pay the invoice long past the due date despite involving legal measures, the accounts receivable are written off as bad debt. 

To facilitate quick and easy payments from customers, it is essential to accept multiple payment methods for receiving payments. Since many organizations rely on check payments, managing and processing checks is also necessary for a business. 

Tracking metrics

Since AR is a major part of a company’s financial well-being, tracking important KPIs and accurately reporting these in the company's financials is an essential part of the accounts receivable process. 

Some important metrics to track to ensure your AR process is running smoothly are: 

• Days Sales Outstanding - DSO
• Accounts Receivable Turnover Ratio
• Collection Effectiveness Index - CEI
• Bad debt
• Average days delinquent

Important metrics in the accounts receivable cycle

Days Sales Outstanding - DSO

The days sales outstanding indicates how long, on average, a company takes to receive customer payment. A high DSO means the company experiences delays in receiving payments, whereas a low DSO indicates the company accepts payments reasonably quickly. 

Accounts Receivable Turnover Ratio

The accounts receivable turnover ratio is the average number of times a company receives customer payments for purchases made on credit. A high turnover ratio indicates that the company collects debt from customers frequently, whereas a low ratio indicates that the company takes time to collect receivables. 

Collection Effectiveness Index - CEI

The Collection effectiveness index measures the percentage of accounts receivable debt a company has collected from its customers in a period. It indicates how well a company’s accounts receivable is being collected. 

Bad debt

Collecting bad debt from accounts receivable harms the company’s financial reputation. If the bad debt is increasing over time, it is an indicator of inefficient collection management practices. Reducing bad debt indicates that the company’s accounts receivable processes are going in the right direction. 

Average days delinquent

Average days delinquent refers to the average number of days past due on the company’s invoices. It is also a good indicator of the company's collection strategies and when to improve them. 

Benefits of automation in the accounts receivable cycle

Like AP automation software, accounts receivable automation software aims to automate the end-to-end accounts receivable cycle, from invoice creation and sending, payment collection to payment reconciliation. 

Automation accounts receivable functions let you generate and send timely invoices and reduce logistics costs, facilitating early payments. It also helps you mitigate the risk of invoice fraud by ensuring a secure invoice and payment transfer method. Automating collection procedures and constant follow-ups can also reduce the burden on your accountant’s plate. With an advanced analytics dashboard, you can easily track problematic customers and monitor their payment behavior. 

Conclusion

• Accounts receivable is the money owed from your customers for sale on credit. 
• The accounts receivable cycle consists of credit approval, sending invoices, deciding payment terms, dispute management, collection management and metrics tracking. 
• The accounts receivable cycle is one of the most critical functions of a company that directly affects the cash flow. 
• It is important to track metrics such as days sales outstanding, accounts receivable turnover ratio, collection effectiveness index, change in bad debt and average days delinquent to ensure the smooth running of the accounts receivable cycle.
• Accounts receivable automation can help companies economically create and send invoices in a timely manner while mitigating risks to facilitate early payments.