When managing your own business’ finances, you may have come across the phrase ‘accounts receivable’. This is a method of accounting for unpaid invoices. It might seem complex, but in this article, we’ll explain how accounts receivable works in business by looking at the following:
- What accounts receivable is
- What accounts payable is
- How accounts receivable works in practice
- A step by step guide on how to manage accounts receivable
- What happens if the customer doesn’t pay the invoice
- A step by step credit control process
What is accounts receivable?
Accounts receivable is any amount of money owed to you by a customer or client that has not paid their bill for your services. If you offer credit to your customers, it might be money you are owed from a product purchase on credit (for example, if you offer store accounts where they can buy now and pay later) or a straightforward invoice that has yet to be repaid.
It might help to think about accounts receivable as a pretend bank account where all your invoices go until they are paid and moved into your actual bank account (where they become revenue).
Accounts receivable gets its name from the fact that you are legally entitled to receive that money as revenue in return for your services. You will find that there are two subcategories of accounts receivable:
- Trade receivables – this is the money owed to you by clients for your business services. This is where the majority of the accounts receivable total will come from.
- Non-trade receivables – sometimes, you might be owed money that is not related to the services your business provides. This could be an insurance payout or a tax rebate that you are due but hasn’t landed in your business account yet.
You record your accounts receivable as a current asset (valuable items you intend to sell within a year) on your balance sheet.
The balance sheet is a financial document businesses use to monitor their debts and owed monies and the overall health of their finances. On the balance sheet, you add up your business’ assets against its liabilities and equity. Your assets are cash or valuable items; liabilities are money owed or your accounts payable like bills, debts, loans; and equity is the company’s total value, which is the total value of assets minus the total value of liabilities.
Therefore, including your accounts receivable total in your assets is key to understanding the full picture of your financial situation and other financial reports that may rely on it.
What is accounts payable?
On the flipside, accounts payable refers to everything your business owes.
This could be to suppliers if you have a running contract for products or supplies with them. Or it could be to any creditors you owe, including lenders, banks, car agencies for leasing any work vehicles, or companies you have contracted for work such as plumbing maintenance or ad hoc repairs.
Your accounts payable counts as a liability for your business. It is essential that you manage them effectively and responsibly as it could impact your business or your personal credit file if your debts are not repaid efficiently. Paying regularly and on time is not only respectful to your creditors, and can help you create lasting business relationships, but also helps maintain confidence in your company’s ability to repay debts.
Be careful that you do not confuse accounts receivable with accounts payable when doing your business accounting. To clarify once more: accounts receivable is money you are owed, and accounts payable is money that your business owes.
How does accounts receivable work in practice?
Let’s look at an example of how accounts receivable works in a business setting.
Step 1: Provide services
Let’s say you are a sole trader running a plumbing business. On 1 March, you fix a customer’s boiler. After ordering parts and returning to the site, you finish the job on 3 March.
Step 2: Invoice the client
When you finish fixing the boiler on the 3rd, you issue the customer with an invoice.
This could be a paper invoice or a digital one. Apps like Countingup allow you to automate invoices, which automatically reconcile once paid, so look into the most appropriate way for you to manage yours.
As per invoicing standards, you should assign it a unique number so that you can easily reference it if needed. It is also a requirement for self-employed invoicing from HMRC.
Invoices should also include relevant information like a breakdown of the goods or services you provided, any parts you had to source, and the cost of your labour. These should all be separate on the invoice so it is clear to your customer what they are paying for. The total amount should be highlighted underneath your breakdown.
Other things to include are:
- A customer reference (for your own records and so you can quickly find the customer details should they get in touch with you again)
- Your company name, address and VAT number (if applicable)
- Your customer’s details (either personal or company information)
- Contact details for your business, and for whoever is responsible for chasing the businesses invoices, if it’s not yourself
Don’t forget to include how your customer can pay. You can leave your business bank account details on the invoice, so they can pay via online banking, or mention if you take cash, card or a cheque. Make it simple for the customer to find a way to pay you, for a quickly paid invoice and a better customer experience.
You will then stipulate on the invoice the payment term that the customer should pay you within. The legal requirement for invoice payment in the UK is within 30 days of the service or product being received. So in the example above, your customer has 30 days from 3 March to pay you for your work.
Step 3: Recording as accounts receivable
In your bookkeeping records for that month, you will have an entry in your Account Receivable ‘account’ for the total cost of the job from 1 March until the customer pays the invoice.
You can use a simple spreadsheet to record the total, invoice number, date issued, and date due to all accounts receivable invoices. This way, you’ll know when to chase up any unpaid invoices and you’ll see the totals you are owed clearly for any financial reports you are pulling together.
Add up all the unpaid invoices for the month and you can add this to your Current Asset total. Assets are a cash total of all the valuables that your business owns, such as money in the bank, machinery or vehicles. Current assets, meanwhile, are valuables that you’re likely to turn into cash in the next 12 months. As the money is legally owed to you, and you will have it in your pocket in the short term (before 30 days is up), you can count it as an asset. If you need to find out more about your business assets, you can read an article from Countingup here.
You then use your asset total in your business balance sheet and in your cash flow statements. Using reports and statements such as these regularly will help you to monitor the financial health of the business, and you will need to know your accounts receivable to do this.
Step 4: After payment is received
Once your customer has paid the invoice, you can then move the total cost out of the balance of your assets and into your revenue total. This is because the money will have been paid into your business current account and is no longer in the ‘pretend bank account’ we mentioned earlier. Your revenue (money made from services) will still be counted as an asset, but you have to separate the money in the bank from the money due to come in to have a good understanding of what your current cash flow is.
Without separating these financial items, you may find yourself running into financial problems because you won’t know where the issues originate. Having detailed reports is very important to running your own business smoothly, and apps such as Countingup can help you gain a better understanding of your finances.
What if my customer doesn’t pay their invoice?
If your invoice hasn’t been paid within the legal 30 days (or the time you agreed), then start by checking to make sure you included all the correct information and sent it to the right customer. Double-check your invoice date, payment amounts, customer details (name, trading name and address) and the details of how to pay your business.
Many small businesses feel ‘awkward’ or ‘rude’ following up on late payments. 77% said they worry about damaging client relationships, while 76% think following up on outstanding invoices will hurt their chances of getting paid at all. Yet, having a clear credit control process starts conversations around late payments, reminds customers who have genuinely forgotten, and shows your business takes its work seriously.
The Countingup app makes it easy to create professional invoices on the go that you can send to clients right away, but here is a process you should follow if invoices are late.
Credit control process
When you are following up on unpaid invoices, keep a record of all communications you send and receive, as this proof will support your case if you need to resort to legal means. For example, send an email after you do a follow-up call, summarising what was said and ask for confirmation.
2 days late…
After your invoice is two days late, send a polite email to ask about the outstanding invoice and when you can expect payment.
7 days late…
Send another email and ask if there’s a reason they haven’t paid, such as a problem with the work delivered, a question about the amount, etc.
8 days late…
Call your contact to make sure they’ve received your emails and ask if there’s a problem with the invoice and when you can expect payment. Remember to send an email summary after the call to create a record of what was discussed.
15 days late…
Make another phone call to remind your client of the outstanding debt. Again, ask why the payment is late and when you can expect to receive it. Send an email after the call to create a record of the conversation.
21 days late…
Send a friendly collection letter to your client to explain that the invoice will now start to accrue interest. You can charge a ‘statutory interest’ of 8% plus the Bank of England base rate for B2B transactions unless otherwise agreed in the contract of your work. In this case, you will need to send a new invoice with the updated payment amount.
35 days late…
Send a final notice letter or another formal collection letter from your company or your business’ lawyer. Include the original invoice date, outstanding amount, services provided, contact person and payment terms. Inform your customer that you’ll take legal action or progress to a debt collection agency if payment isn’t received within seven days.
42 days late…
If your invoice hasn’t been paid by now, you’ll probably need to enlist outside help like invoice factoring, debt collection agencies or legal action, such as small claims court or mediation.
If you have an accountant, they can also help you set up a credit process such as this, or may even chase invoices for you, depending on what services they offer.
Save time on financial admin with Countingup
Countingup is the business current account and accounting software in one app. You can use it to automate your financial admin and save time and stress on your bookkeeping.
The Countingup app comes with automated invoicing features, so you can share payment details with customers with ease. This can make your accounts receivable and turnover calculations easier as you’ll see the exact sums from customers easily.
The Countingup app also offers real-time profit and loss insights and nudges you to keep your financial records up to date, so that you can be confident in the accuracy of your account figures.
Find out more here and sign up for free today.