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How To Calculate Accounts Receivable for New Business Owners

Michael Pignatelli
Last Updated on September 28, 2023

Learning how to calculate accounts receivable is an important step towards better financial management, and the reason is obvious for anyone that owns a business; nobody wants to forget the money they're owed, especially when it's a huge amount.

In this blog, we'll discuss everything there is to know about accounts receivable, the formulas involved in calculating it, and why you need to keep tabs on this account that's on your company's balance sheet.

Understanding Accounts Receivable

For starters, let's discuss what accounts receivable is. The short of it is that it's the money that customers owe a business on credit. But how does that happen exactly?

Accounts receivable are recorded on the business's books when a customer receives goods or services from the business but can't pay at the time of purchase.

For example, an Amazon seller may provide products to a client and invoice them for the products. If the client does not pay immediately, the amount owed by the client for the products is recorded as an accounts receivable.

Accounts receivable can also be accrued through installment payments or financing arrangements, such as when a customer purchases a product on credit and pays for it over time.

During the pandemic, many businesses learned that proper accounts receivable management can lead to sturdy financial positions. You see, accruing accounts receivable allows businesses to provide flexibility to their customers while still being able to track and manage the money owed to them. 

Accounts Receivable vs. Accounts Payable

Owing money can also work both ways. With accounts receivable, a business is owed by its customers for every product or service it sells on credit. Accounts payable is the opposite. It happens when the business owes its vendors or suppliers money for goods or services received but has yet to pay for them.

On the balance sheet, both accounts are recorded differently. Accounts receivable are recorded as assets, while accounts payable are considered liabilities. 

A good balance between accounts receivable and accounts payable is critical for maintaining a healthy cash flow and financial stability.

Recognizing Accounts Receivable

Accounts receivable is only recognized as an asset when a business has a legal right to receive payment from a customer for goods or services that have been provided but not yet paid for.

Accounts receivable are classified as a current asset because it is expected to be collected relatively quickly, typically within 30 to 60 days. As such, accounts receivable represent an essential component of a business's overall financial health, as it reflects the amount of cash the business expects to receive soon.

Under the cash basis accounting method, accounts receivable are only recorded once payment is received. Any sales made on credit or outstanding invoices are recorded as revenue once the payment is received. Hence, the accounts receivable balance remains zero until the customer pays.

On the other hand, under the accrual accounting method, accounts receivable are recorded as soon as the sale is made or the service is provided, even if payment has yet to be received. This means that the revenue is recognized at the time of the sale or service, regardless of when payment is received. The accounts receivable balance reflects the total amount owed by customers as of the end of the reporting period.

Methods of Calculating Accounts Receivable

So how do you calculate accounts receivable? Do you rely on accounting software to handle everything financial-related? Do you hire an accountant to deal with the math?

The truth is, it's best if new business owners like yourself understand how it's calculated to better maneuver net sales and other essential accounts in your day-to-day transactions.

Currently, there are two standard methods for accounts receivable calculation: the balance sheet method and the aging method.

The balance sheet method involves taking the total accounts receivable balance on the balance sheet and subtracting any allowances for doubtful accounts.

The allowance for doubtful accounts is an estimated amount of uncollectible debts based on experience or other factors. The result is the net accounts receivable balance, which represents the amount the business expects to collect from its customers.

Accounts Receivable (AR) - Allowance for Doubtful Accounts (ADA) = Net Accounts Receivable (NAR)

The aging method involves categorizing the accounts receivable by the age of the invoice or outstanding payment. Typically, businesses will group the accounts receivable in 30-day intervals, such as current, 1–30 days, 31–60 days, and so on.

For each age category, the business estimates the percentage of the outstanding balance likely to be collected. This percentage is based on historical data or industry averages. The sum of the estimated amounts for each age category is the total estimated accounts receivable balance.

(Amounts outstanding up to 30 days × Estimated percentage collectible) + (Amounts outstanding 31–60 days × Estimated percentage collectible) + (Amounts outstanding 61–90 days × Estimated percentage collectible) + (Amounts outstanding over 90 days × Estimated percentage collectible) = Total estimated accounts receivables

Which Method Should I Use?

The balance sheet method is simple and quick but provides less detailed information on the accounts receivable than the aging method.

The aging method takes more time and effort to calculate, but it provides a more detailed breakdown of the accounts receivable by age, which can help determine which invoices are most overdue and require immediate attention.

Ultimately, businesses should choose the best method for their needs and resources.

Business owner managing accounts receivable

Analyzing Accounts Receivable

Analyzing accounts receivable is vital for cash flow, financial planning, and risk management. It allows businesses to identify areas where they may be experiencing delays in payment or facing issues with collection, enabling them to take corrective action and improve their cash flow.

By understanding the trends and patterns in their accounts receivable, businesses can make more accurate financial projections and plan for future growth.

Now, there are several metrics that businesses can use to analyze accounts receivable. Here are some of the most commonly used ones.

Accounts Receivable Turnover Ratio

This ratio measures how often a business collects its average accounts receivable balance during a given period. The accounts receivable turnover ratio formula is:

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

A high ratio indicates that the business is collecting its receivables in a timely manner, while a low ratio indicates that the business is taking a long time to collect its receivables or needs a better collection process.

Days Sales Outstanding (DSO)

DSO measures the average number of days it takes for a business to collect payment on its sales. The formula for DSO is:

DSO = (Accounts Receivable / Net Credit Sales) x Number of Days in the Period

Unlike the accounts receivable turnover ratio, a lower DSO indicates that a business collects payment more quickly. In comparison, a higher DSO indicates that the business is taking longer to collect a payment, which can lead to cash flow problems and may require additional efforts to improve the accounts receivable collection process.

Bad Debt Ratio

This ratio measures the percentage of accounts receivable the business writes off as bad debt. The formula is:

Bad Debt Ratio = (Total Bad Debts / Net Credit Sales) x 100

A lower lousy debt ratio indicates that the business effectively manages its accounts receivable and minimizes the risk of bad debts.

Average Collection Period

This metric measures the average number of days it takes for a business to collect payment on its accounts receivable. The formula is:

Average Collection Period = (Accounts Receivable / Net Credit Sales) x Number of Days in the Period

A lower average collection period indicates that the business is collecting payment more quickly, while a higher average collection period indicates the business is taking a long time to collect payment.

Managing Accounts Receivables

In the same way that we ought to calculate accounts receivable accurately, we want to be sure that we're managing collections responsibly. The goal is always to what your company collects so we can avoid future financial difficulties and maximize the company's ability to generate revenue.

To better manage your accounts receivables, here are a few tips that can help:

  1. Establish Clear Payment Terms: Communicating payment terms to customers at the outset can help avoid misunderstandings and reduce the likelihood of late payments. Payment terms should include the payment due date, accepted forms, and consequences for late payments.
  2. Invoice Promptly: Invoicing customers promptly can help ensure timely payment. Automated invoicing systems can streamline the process and reduce delays.
  3. Follow-Up on Overdue Payments: Regularly following up with customers on overdue payments is essential for ensuring timely payment. This can involve sending reminders or making phone calls to customers.
  4. Offer Incentives for Early Payment: Offering incentives such as discounts or other perks for early customers can encourage prompt payment and reduce the likelihood of late payments.
  5. Conduct Credit Checks: Conducting credit checks on new customers can help identify potential credit risks and avoid the risk of bad debts.
  6. Use Collection Agencies as a Last Resort: If all other attempts to collect payment have failed, businesses may need to use a collection agency. However, this should be considered a last resort, as collection agencies often charge high fees and may harm the business's relationship with the customer.
Business owner working with accounting experts

Work With Accounting Experts

In conclusion, calculating and managing accounts receivable is critical to a business's financial health. It is important to regularly analyze accounts receivable, identify issues, and implement effective strategies to manage them.

At Unloop, we understand that and want to ensure you succeed. 

By working with our accounting experts, you can focus on running your business while we handle your accounting needs, ensuring that your business stays on track and financially healthy—we’ve even got accounts payable services!

Contact us today to learn how we can help you manage your accounts receivable and achieve financial success.

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About unloop

Unloop is the first and only accounting firm exclusively servicing ecommerce and inventory businesses in the US and Canada. With the power of people and technology, our team dives deep into COGS and inventory accounting. You are paired with a dedicated bookkeeping team that prepares accurate financial statements, financial forecasts, and can also pay bills or run payroll for you. Come tax time, everything is organized and ready to go, so you don't need to worry. Book a call with an ecommerce accountant today to learn more.