Formula and Calculation for Accounts Receivable Turnover Ratio
Accounts Receivable Turnover = Net Credit Sales / Average Accounts Receivable
- Add the value of accounts receivable at the beginning of the desired period to the value at the end of the period. Next, divide the sum by two to get the average of the start and end point. The result is the denominator in the formula.
- Divide the value of net credit sales for the period by the average accounts receivable during the same period.
- Net credit sales are the revenue generated from sales that were done on credit minus any returns from customers. Cash sales are not included as they create no accounts receivable.
What Is the Receivables Turnover Ratio?
The accounts receivable turnover ratio is an accounting measure. It is used to identify how effective a company is in collecting its receivables. Receivables are nothing more than the money owed by clients for products and services they receive up front. The ratio shows how well a company uses and manages the credit it extends to customers. It can also indicate how quickly that short-term debt is collected or is paid. The receivables turnover ratio is also called the accounts receivable turnover ratio.
AR Turnover Ratio – Key Concepts
- Accounts receivable turnover ratio is an accounting measure used to quantify a company’s effectiveness in collecting its receivables or money owed by clients.
- High receivables turnover ratio can indicate that a company’s collection of accounts receivable is efficient and that the company has a high proportion of quality customers that pay their debts quickly.
- Low receivables turnover ratio might be due to a company having a poor collection process, bad credit policies, or customers that are not financially viable or creditworthy.
- Receivable turnover in days – Dividing 365 by the accounts receivable turnover ratio yields the accounts receivable turnover in days, which gives the average number of days it takes customers to pay their debts.
- AR turnover should be monitored – A company’s receivables turnover ratio should be monitored and tracked to determine if a trend or pattern is developing over time.
Receivables Turnover Ratio – What it Reveals
Companies that maintain accounts receivables are indirectly extending interest-free loans to their clients. This is because accounts receivable is money owed without interest. If a company generates a sale to a client, it might extend terms of 30, 45 or 60 days for payment. In reality, this means the client has 30 to 60 days to pay for the product while paying no interest.
The receivables turnover ratio measures how efficient a company is in collecting outstanding payments from customers. Remember, receivables is nothing more than credit extended to customers for goods or services purchased. The ratio also measures how many times a company’s receivables are converted to cash in a given period. The receivables turnover ratio can be calculated on an annual, quarterly, or monthly basis.
High Accounts Receivable Turnover Ratio
A high receivables turnover ratio can indicate that a company’s collection of accounts receivable is efficient. Also, that the company has a high proportion of quality customers that pay their debts quickly. However, sometimes a high receivables turnover ratio might also indicate that a company operates on a cash basis. In general, the higher the accounts receivable turnover rate the better. A higher ratio can mean:
- You receive payment for debts, which increases your cash flow.
- Your collections methods are effective.
- You’re extending credit to the right kinds of customers, meaning you don’t take on as much bad debt.
- Your customers are paying off debt quickly, freeing up credit lines for future purchases.
Low Accounts Receivable Turnover Ratio
A low receivables turnover ratio might indicate a number of potential causes:
- Poor Collections Process – weak or inneffective methods for collection of outstanding payments
- Bad credit policies
- Customer Screening – extending terms to customers that are not financially viable or creditworthy.
In general, a low turnover ratio implies that the company should reassess its credit policies. Companies need to take the necessary steps to ensure the timely collection of its receivables. As a bonus, when a company with a low ratio improves its collection process, it can lead to a windfall of cash from collecting on old credit or receivables.
Tracking Receivables Turnover Ratio
Any company that extends payment terms to its customers should track its receivables turnover ratio. This data should be monitored to determine if a trend or pattern is developing over time. Also, companies can track and correlate the collection of receivables to earnings. This practice can measure the impact the company’s credit practices have on profitability.
Receivables Turnover vs. Asset Turnover Ratio
Receivables turnover and asset turnover are both measures of a company’s efficiency. One measures how efficiently a company collects its outstanding credit, the other measures how efficiently a company uses its assets. Both are valuable metriccs, but they measure different things:
- The accounts receivable turnover ratio measures a company’s effectiveness in collecting its receivables or money owed by clients. The ratio shows how well a company uses and manages the credit it extends to customers and how quickly that short-term debt is collected or being paid.
- The asset turnover ratio measures the value of a company’s revenues relative to the value of its assets. The asset turnover ratio reveals the efficiency with which a company uses its assets to generate revenue. The higher the asset turnover ratio, the more efficient a company’s use of assets. And, if a company has a low asset turnover ratio, it raises the flag it might not efficiently be using its assets to generate sales.
Receivables Turnover Ratio Limitations
The accounts receivable turnover ratio measures a companies effectiveness in collecting money owed by clients. While it is a valuable metric, it comes with a set of limitations. These shortcomings are important for any investor to consider before relying blindly on the turnover ration alone.
Turnover Ratio Interpretations
- Total Sales vs Net Sales – Some companies use total sales instead of net sales when calculating their turnover ratio, which inflates the results. While this is not always necessarily meant to be deliberately misleading, investors should try to verify how a company calculates its ratio or calculate the ratio independently.
- Seasonal Variation – Another limitation to the turnover ratio is that accounts receivables can vary dramatically throughout the year. For example, companies that are seasonal will likely have periods with high receivables along with perhaps a low turnover ratio and periods when the receivables are fewer and can be more easily managed and collected.
- Use Consistent Data Points – Starting and ending point for calculating the receivables turnover ratio should not be chosen arbitrarily. This can result in the ratio not accurately reflecting the company’s effectiveness of issuing and collecting credit. The beginning and ending values selected when calculating the average accounts receivable should be carefully chosen. For example, investors could take an average of accounts receivable from each month during a 12-month period. This will help to smooth out any seasonal variations.
- Compare Similar Operations – Any comparisons of the turnover ratio should be made with companies that are in the same industry. Ideally, they should also have similar business models. Companies of different sizes may often have very different capital structures. This can greatly influence turnover calculations. The same is often true of companies in different industries.
- Returned Goods – Low receivables turnover might not necessarily indicate that the company’s collections process is lacking. For example, if the company’s distribution division is operating poorly, it might be failing to deliver the correct goods. As a result, customers might delay their payments. This would decrease the company’s receivables turnover ratio.
Example: Receivables Turnover Ratio Calculation
For example, the CaseStudy Company wants to determine the company’s accounts receivable turnover for the past year. In the beginning of the year, accounts receivable balance was $400,000, and the ending balance was $440,000. Net credit sales for the last 12 months were $4,500,000. Based on this information, the accounts receivable turnover can be calculated:
- Net credit sales of $4,500,000
- $400,000 in accounts receivables on January 1st or the beginning of the year
- $440,000 in accounts receivables on December 31st or at the end of the year
$4,500,000 Net credit sales ÷ (($400,000 Beginning receivables + $440,000 Ending receivables) / 2)
= $4,500,000 Net credit sales ÷ $420,000 Average accounts receivable
= 10.71 Accounts receivable turnover
CaseStudy’s accounts receivable turned over 10.71 times during the past year. The ratio indicates that CaseStudy collected its receivables 10.71 times on average that year. In other words, the company converted its receivables to cash 10.71 times. A company could compare several years to determine whether 10.71 is an improvement or an indication of a slower collection process.
Calculating Accounts Receivable Turnover in Days
The accounts receivable turnover in days shows the average number of days that it takes a customer to pay the company for sales on credit. The formula for the accounts receivable turnover in days is as follows:
Receivable turnover in days = 365 / Receivable turnover ratio
Determining the accounts receivable turnover in days for CaseStudy Company in the example above:
Receivable turnover in days = 365 / 10.71 = 34 days
Therefore, the average customer takes approximately 34 days to pay their debt. Let’s suppose CaseStudy Company maintains a policy for payments made on credit, such as a 30-day policy. In that case, the receivable turnover would indicate that the average customer makes late payments, but only by a few days.
A company could improve its turnover ratio by making changes to its collection process. A company could also offer its customers discounts for paying early. It’s important for companies to know their receivables turnover since its directly tied to how much cash they’ll have available to pay their short term liabilities.
Understanding Your Accounts Receivable Turnover Ratio
Understanding your accounts receivable turnover ratio can be important for your business management and planning. By learning how quickly your average debts are paid, you can try to determine how your cash flow will look. This will allow you to better plan your expenses in the coming months. Plus, correcting collections issues can improve cash flow and help you reinvest in your business for additional growth.
Improving your turnover ratio can also help you get a business loan. Many bankers and lenders use accounts receivable as collateral. By improving your accounts receivable turnover ratio, you can improve the level of collateral you can offer. This can result in significantly better loan terms.
There are a variety of ways you can improve this ratio. You can tighten collections policies to collect on more payments, or you can offer incentives to customers who pay quickly. The course of action you choose, depends on what you determine most greatly affects your existing ratio. By changing your policies to improve your ratio, you’ll be helping your cash flow, loan possibilities, and overall financial planning. All of these results can have a positive impact on the success of your small business.
Ways to Improve Your Accounts Receivable Turnover Ratio
One of the top priorities of business owners should be to keep an eye on their accounts receivable turnover. Sales and excellent customer service is important but a business can’t run on a low cash flow. Collecting your receivables is a definite way to improve your company’s cash flow. Here are a few tips to help you improve your Accounts Receivable process to cut down collection calls and improve your cash flow.
Tips to Improve AR Turnover
- Proper Invoicing – The more accurate and detailed your invoices are, the easier it is for your customers to pay that bill. Billing on time and often will also help your company collect its receivables quicker.
- Strong Customer Relationships – A good relationship with your customers will help you get paid. Happy customers are happy to pay for the goods and services provided. Big and small companies alike can benefit from making small friendly gestures like a friendly call or e-mail to check in. Small gestures can make a big difference during collections time.
- Payment Terms – Add clear payment terms on your invoices. Make sure you make it clear that you expect payment within 30 days. Don’t be afraid to add in late payment fees. This fee is usually a percentage of the original invoice. Consider setting credit limits or offering payments plans for high dollar value sales.
- Make Payment Easy – Provide multiple ways for your customers to pay their invoices. This will make it easier for them to match their own financial process. Ease of payment will help you get paid faster. Consider accepting online payments through Apple Pay or PayPal as well as traditional methods of checks and cash.
- Follow Up – Friendly reminders for payment don’t just need to come when a payment is late. Think about giving your problem customers a courtesy call or email. You can remind them their payment is due 10 days before the invoice due. After the due date passes, follow up again right away.
Accounts Receivable Turnover – Final Words
Accounts Receivable Turnover demonstrates the customers influence on the financial condition of a company. A stable ratio reflects a company’s thoughtful policy of cooperation with its buyers and customers. Significant increases to the average collection period can indicate a number of potential problems. One possible intrepretation could be that your credit policy isn’t reasonable. By monitoring your AR turnover ration, swift action can be taken to the maintain the firm’s accounts receivable liquidity. At the same time, shortening the receivables turnover less than the industry standard could result in a restrictive recredit policy and can lead to losing customers. Each industry has norms and standards. It is always good practice to compare your policies with the industry averages.