Collections | B2B Finance Glossary
What Are Collections?
Collections is a process conducted by the finance department's accounts receivable (AR) section. It ensures the business can effectively recover payments from a business, individual, or third party after issuing an invoice to the recipient. The AR department’s job is to collect money owed from any party that the company that has issued an invoice before that invoice is considered to be overdue. The collections process can occur in many ways, but it depends primarily on how the business and the accounting team operate.
How Does a Business Undergo Its Collections Process?
When it comes to collections, it’s important for the finance organization to minimize risk as much as possible – meaning it’s crucial for the AR team to collect payments that are owed on time and that there is a detailed process for approving customer credit. On top of that, having the right accounting software can help ensure that the collections process is organized and timely.
Businesses that automate their AR departments can effortlessly streamline their collections processes by removing human errors and putting rote tasks on autopilot. This also helps reduce the time and money spent keeping the AR department running. On top of that, it allows the finance team to turn their attention to what really matters: strategic planning.
Aging reports can also be helpful in evaluating the effectiveness of the AR department. This report categorizes different outstanding balances customers owe into groups depending on when each balance is past due. The groups typically fall into the following categories: 0-30 days past due, 31-60 days past due, 61-90 days past due, and over 90 days past due. Once the business has made an aging report, it can better strategize how it plans to improve its collections process.
How do Businesses Measure the Success of Their Collections?
On top of conducting an aging report, companies have other tools at their disposal to measure their collections' success: they can use the AR turnover ratio to gather further information. The AR turnover ratio is a fraction used to measure AR collections. This ratio indicates how successful a business is at converting debt that’s owed by customers into payments that can be collected by the AR department.
To calculate the receivable turnover ratio, finance teams will first have to add the balance for AR that exists at the beginning of the reporting period to the balance that exists at the end of this period; then, this sum will need to be divided in half to show the average value of all of AR that exists for that period.
Next, the finance organization has to start with the total value of sales that still exist on credit for the accounting period in question and then divide this figure by the average value of AR that was calculated just before. This is how the finance team creates the AR turnover ratio itself.
What Can Finance Teams Learn From the AR Turnover Ratio?
Once the AR turnover is calculated, it’s important for finance teams to know what the results mean and how these results directly impact their business. A large number is a positive sign for the company's overall financial well-being. A high number reveals that the business is converting more credit sales into actual revenue.
On the other hand, a smaller number indicates poor financial health because the business is converting a smaller percentage of its credit sales directly into revenue that can be used to sustain the business.
How Can Finance Teams Recover Overdue Collections?
A dunning letter is a collection notice sent to customers to show that their payments are overdue. Dunning letters collect outstanding past-due receivables and prevent accounts from becoming delinquent.
Businesses can also ensure that outstanding collections do not become past due by creating a more efficient AR department, streamlining collection processes, offering customers things like discounts if payments are made early, or offering customers payment plans to help make paying off what’s owed easier.
What Happens When AR Departments Cannot Collect What’s Owed?
Suppose a certain invoice has remained outstanding for so long, and the AR department is continuously unsuccessful in collecting the payment. The amount due is passed along to a collections agency in that case. A collections agency is a third party to which a particular business sells its debt at a fraction of what is owed. This allows the business to recoup some of what is owed without sacrificing time to pursue the debt.
The collections agency is then charged with collecting the payment from the individual, party, or business that owes the debt. The agency can pursue the debt indefinitely, or at least until the statute of limitations runs out. How the collections process plays out depends on the company collecting the debt, how much is owed, and what type of debt is owed.