The accounts receivable turnover ratio is a simple metric that is used to measure how effective a business is at collecting debt and extending credit. It is calculated by dividing net credit sales by average accounts receivable. The higher the ratio, the better the business is at managing customer credit.
Key Takeaways
- The AR turnover ratio is an efficiency ratio that measures how many times a year (or set accounting period) that a company collects its average accounts receivable.
- To calculate the AR turnover down to the day, divide your ratio by 365. This is the average number of days it takes customers to pay their debt.
- A “good” turnover ratio all depends on the industry but in general, you want it to be high. This suggests a company’s collection process is efficient and they have a high-quality customer base. It also indicates a business has a conservative credit policy.
- A continuously low turnover rate should be addressed immediately. It suggests a poor collection process, un-creditworthy customers, or a credit policy that’s too long.
- Accounting software can help a business raise its accounts receivable turnover ratio by automating key processes that manual labor slows down. This includes automated invoicing, PO matching, and bank reconciliation.
What is Accounts Receivable Turnover Ratio?
The accounts receivable turnover ratio (also called the “receivable turnover” or “debtors turnover” ratio) is an efficiency ratio used in financial statement analysis. It demonstrates how quickly and effectively a company can convert AR into cash within a certain accounting period. It is a component in the full accounting cycle of running a business.
The ratio is also used to quantify how well a company manages the credit they extend to customers, and how long it takes to collect the outstanding debt. The ratio itself measures how many times a company collects AR (on average) throughout the year.
Calculating Accounts Receivable Turnover Ratio
The Accounts receivable turnover ratio is calculated by dividing net credit sales by the average accounts receivable.
Net sales is everything left over after returns, sales on credit, and sales allowances are subtracted.
Average accounts receivables is calculated as the sum of the starting and ending receivables over a set period of time (usually a month, quarter, or year). That number is then divided by 2 to determine an accurate financial ratio.
AR Ratio Formulas
Net Sales
Gross Sales – Refunds/Returns – Sales on Credit = Net Sales
Average Accounts Receivables
(Beginning Accounts Receivable + Ending Accounts Receivable) ÷ 2 = Average AR
Accounts Receivables Turnover
Net Annual Credit Sales ÷ Average Accounts Receivables = AR Turnover
Accounts Receivable Turnover in Days
Accounts Receivables Turnover Ratio ÷ 365 = AR Turnover (in days)
In financial modeling, the accounts receivable turnover ratio is used to make balance sheet forecasts. In order to know the average number of days it takes a client to pay on a credit sale, the ratio should be divided by 365 days.
The AR balance is based on the average number of days in which revenue is received. Revenue in each period is multiplied by the turnover days and divided by the number of days in the period.
How to Calculate Accounts Receivable Turnover Ratio (Step by Step)
In order to calculate the accounts receivable turnover ratio, you must calculate the nominator (net credit sales) and denominator (average accounts receivable).
The following is a step-by-step guide to getting those numbers and a final AR turnover ratio.
- Calculate average accounts receivable. Add the value of AR at the beginning of your desired period, to the value at the end and divide by two. This gets you the denominator in the equation, the average accounts receivable.
- Calculate the net credit sales. This is the revenue generated from credit sales, minus any returns. This number forms the nominator in the equation.
- Calculate the accounts receivable turnover ratio. Both numbers should represent the same accounting period. The accounts receivable turnover ratio formula looks like this:
Accounts Receivable Turnover Ratio = Net Credit Sales / Average Accounts Receivable - Calculate the AR turnover in days. If you want to know more precise data, divide the AR turnover ratio by 365 days.
Receivable turnover in days = 365 / Receivable turnover ratio
The accounts receivable turnover ratio is generally calculated at the end of the year, but can also apply to monthly and quarterly equations and predictions. A small business should calculate the turnover rate frequently as they adjust to growth and build new clients.
When is the Accounts Receivable Turnover Ratio Used?
A company’s accounts receivable turnover ratio is most often used to quantify how well it can manage extended credit. It’s indicative of how tight your AR practices are, what needs work, and where lies room for improvement.
A debtor’s turnover ratio demonstrates how effective their collections process is and what needs to be done to further collect on late payments. The longer the days sales outstanding (DSO), the less working capital a business owner has. This is where poor AR management can also affect your accounts payable functions.
Examples of Accounts Receivable Turnover Ratio
Every business sells a product and/or service that must be invoiced and collected on, according to the terms set forth in the sale. However, there are variances in how companies manage their collections. There’s a right way and a wrong way to do it and the more time spent as a “lender”, the more likely you are to incur bad debt.
Here are some examples in which an average collection period can affect a business in a positive or negative way.
High Accounts Receivable Turnover Ratio
By accepting insurance payments and cash payments from patients, a local doctor’s office has a mixture of credit and cash sales. The accounts receivable turnover rate is 10, which means the average accounts receivable is collected in 36.5 days (10% of 365 days).
This bodes very well for the cash flow and personal goals in the small doctor’s office. However, if credit policies are too tight, they may struggle during any economic downturn, or if competition accepts more insurance and/or has deep discounts.
Low Accounts Receivable Turnover Ratio
A large landscaping firm runs service for an entire town, from apartment complexes to city parks. However, the staff is always shorthanded and overworked. Thus, invoices do not reach customers right away, as the team is focused more on providing the service.
Even though the customers generally pay on time, the accounts receivable turnover ratio is low because of how late the business invoices. The total sales have little effect on this issue and the AR ratio is at a low 3.2 due to sporadic invoices and due dates. This means, the AR is only turning into bankable cash 3 times a year, or invoices are getting paid on average every four months.
This can lead to a shortage in cash flow but it also means that if the business simply hired more workers, it would grow at exponential rates.
What is a Good Accounts Receivable Turnover Ratio?
As you can see above, what determines a “good” accounts receivable turnover ratio depends on a variety of factors. Holding the reins too tight can have a negative impact on business, whereas being too lackadaisical about collections leads to limited cash flow.
In general, a higher number is better. It indicates customers are paying on time and debt is being collected in a proper fashion. It can point to a tighter balance sheet (or income statement), stronger creditworthiness for your business, and a more balanced asset turnover.
What is a good number for the AR turnover ratio? It all depends on your industry. As we saw above, healthcare can be affected by the rate at which you set collections. It can turn off new patients who expect some empathy and patience when it comes to paying bills.
Do you want a higher or lower accounts receivable turnover?
A high AR turnover ratio means a business is not only conservative about extending credit to customers, but aggressive about collecting debt. This can be good for the pocket, but bad for customer service. It can also indicate that the company’s customers are of high quality and/or it runs on a cash basis.
In some instances, a lower ratio might get you more customers. However, if you have a low ratio long enough, it’s more indicative that AR is being poorly managed or a company extends credit too easily. It can also mean the business serves a financially riskier customer base (non-creditworthy) or is being impacted by a broader economic event.
A consistently low ratio indicates a company’s invoice terms are too long. The credit policy needs to be reigned in. This can sometimes happen in earnings management, where sales teams are extending longer periods of credit to make a sale.
Ultimately, the time value of money principle states that the longer a company takes to collect on its credit sales, the more money it effectively loses (i.e. the less valuable sales are). Therefore, a declining AR turnover ratio is seen as detrimental to a company’s financial well-being.
It’s useful to periodically compare your AR turnover ratio to competition in the same industry. This provides a more meaningful analysis of performance rather than an isolated number.
What’s the Purpose of Accounts Receivable Turnover Ratio?
The accounts receivable turnover ratio serves more of a purpose than simple bookkeeping. It enables a business to have a complete understanding of how quickly payments are being collected. This leads to more cash in hand and opportunities for strategic planning.
Examining these figures also helps to determine if the credit policies and practices being carried out support a positive or negative cash flow for the business. If it is not adding to continued business growth, it is taking away from it, and operations must be adjusted accordingly.
Financial Modeling
Perhaps one of the greatest uses for the AR turnover ratio is how it helps a business plan for the future. You cannot begin to configure predictive analytics without base numbers first. The accounts receivable turnover ratio is an important assumption for driving a balance sheet forecast and making accurate financial predictions.
Limitations of the Accounts Receivables Turnover Ratio
Like any business metric, there is a limit to the usefulness of the AR turnover ratio. It’s critical that the number is used within the context of the industry. For example, collecting on office supplies is a lot easier than collecting on a surgical procedure or mortgage payment.
Additionally, some businesses have a higher cash ratio than others, like comparing a grocery store to a dentist’s office. Therefore, the accounts receivable turnover ratio is not always a good indicator of how well a store is managed.
Manufacturing usually has the lowest AR turnover ratios because of the necessary long payment terms in the contracts. The projects are large, take more time, and thus are invoiced over a longer accounting period.
In general, an AR turnover ratio is accurate at highlighting customer payment trends in that industry. However, it can never accurately portray who your best customers are since things can happen unexpectedly (i.e. bankruptcy, competition, etc.).
It should also be noted, any business model that is cyclical or subscription-based may also have a slightly skewed ratio. That’s because the start and endpoint of the accounts receivable average can change quickly, affecting the ultimate receivable balance.
Tips for Improving Your Accounts Receivable (AR) Turnover Ratio
If your AR turnover ratio is low, adjustments should be made to credit and collection policies—effective immediately. The longer you let it go, the harder it will be on positive business cash flow.
Here are a few tips to get you back on track when the AR turnover ratio is slipping:
- Invoice regularly and accurately. It doesn’t matter how busy the office is, no one gets paid if the bills don’t go out. Late invoices equal late payments. Accounting software can automate many aspects of the invoicing process and guard against any errors.
- Offer multiple payment methods. Just like some people prefer emails over phone calls, so they prefer credit cards over checks. The more options you give customers to pay, the faster they will pay you.
- Clearly state payment terms. How can you enforce a policy if it is unclear? All agreements, contracts, and invoices should state the terms so customers are not surprised when it comes time to collect.
- Stay on it with reminders. Don’t let an invoice sit in someone’s inbox, set up automatic reminders and notifications to keep everyone on track in the collection process. Be proactive, but don’t annoy people. Internal triggers should activate collection efforts sooner, rather than later, but should never be pushy. That’s how you lose customers.
- Consider early-payment discounts. Nothing motivates people more than money in business, and offering your customers a discount to get cash in the door faster is a common collection strategy across every industry. Cash payments can also be used in this instance to improve the ratio.
