Accounts Receivable Turnover Ratio Formula Explained

The accounts receivable turnover ratio is a financial metric used to measure a business’s effectiveness at collecting debt and extending credit. AR turnover is calculated by dividing net credit sales by average accounts receivable. The higher the ratio, the better the business manages customer credit.

What is the 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 quantifies how well a company manages the credit it extends to customers on invoices and how long it takes to collect the outstanding debt. The accounts receivable turnover ratio measures the number of times a company collects AR (on average) throughout the year (or another specific period). 

Companies can benchmark their accounts receivable turnover by comparing it to their industry average. 

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 understand how quickly customer payments are being collected. 

Importance of Accounts Receivable Turnover

Calculating and understanding accounts receivable turnover is important because it leads to faster and more cash on hand, better financial health, and opportunities for strategic planning and growth. Examining these AR turnover figures also helps determine if the company’s credit policies and practices 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. For example, if a business doesn’t emphasize the need for quick collection of its accounts receivable payments, accounts receivable turnover will be too low, and cash flow will be negatively impacted. 

The longer a business has unpaid invoices in its accounts receivable aging, the higher the risk that the invoices won’t be paid because that customer could experience adverse business conditions limiting their cash flow or declare bankruptcy. If the seller doesn’t collect accounts receivable, their cash flow is lower than expected, and they will not have as much cash to use for business expansion. 

The accounts receivable turnover ratio is an important assumption for driving a balance sheet and cash flow forecast to make more accurate financial predictions. 

Financial Modeling

One of the best uses of 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. Using accounts receivable turnover as a financial model assumption improves financial projection accuracy. 

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 the amount after sales returns, discounts, and sales allowances are subtracted from gross sales. Net credit sales are the amount of sales on credit terms. 

Average accounts receivable is calculated as the sum of the starting and ending receivables over a given period of time(usually a month, quarter, or year). That number is then divided by 2 to determine a relatively accurate financial ratio for the timeframe by averaging the beginning and ending balances. 

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 Receivable Turnover

 Net Annual Credit Sales ÷ Average Accounts Receivable = AR Turnover

Accounts Receivable Turnover in Days

Accounts Receivable 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. Note that it is customary practice in the accounts receivable turnover calculation to use 365 days instead of 360 days (as used in banking for commercial loans interest). 

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)

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.

1. 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.
2. Calculate the net credit sales. This is the revenue from credit sales, minus any sales returns, discounts, and allowances. This number from the income statement forms the nominator in the equation.
3. 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
4. Calculate the AR turnover in days. If you want to know more precise data, divide the AR turnover ratio by 365 days, which is called days sales outstanding (DSO).
   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 it adjusts to growth and builds new customers or clients.

Some businesses use Google or Excel spreadsheets to calculate accounts receivable turnover. But some modern accounting and ERP software systems provide automatic turnover ratio calculations and metrics trends.

When is the Accounts Receivable Turnover Ratio Used?

A company’s accounts receivable turnover ratio is often used to quantify how well it manages extended credit. It indicates how tight your AR practices are, what needs work, and where your business can improve. 

A debtor’s turnover ratio demonstrates how effective a company’s collections process is and what needs to be done to collect further 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 as payment from the customer, according to the terms set forth in the sale. However, there are variations 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” with short-term AR invoice debt, the more likely you are to incur  bad debt.

Here are some examples of how an average collection period can positively or negatively affect a business.

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 (365 days divided by 10). 

This is a higher ratio for accounts receivable turnover than the benchmarked medical provider industry average for doctors, but it includes cash payments from some patients. As guidance, Reed Tinsley, CPA, who provides accounting services for physician practices, suggests 18-22% as a benchmark for accounts receivable over 90 days, although that percentage can be improved by collecting quicker. 

This bodes very well for the cash flow and personal goals in the small doctor’s office. However, if credit policies are too tight or competition accepts more insurance and/or has deep discounts, they may struggle during any economic downturn.  

Low Accounts Receivable Turnover Ratio

A large landscaping firm services an entire town, from apartment complexes to city parks. However, the staff is always shorthanded and overworked. Thus, invoices do not reach customers immediately, as the team focuses more on providing the service.

Even though the customers generally pay on time, there is a low turnover ratio for accounts receivable because of how late the business invoices are prepared and sent to customers. The total sales have little effect on this issue, and the AR ratio for the year is 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 paid on average every four months. 

This can lead to a shortage in cash flow, but it also means that if the business simply hires more workers with additional financing, it would grow exponentially. The landscaping businesses would produce a higher accounts receivable turnover ratio with faster invoicing. 

What is a Good Accounts Receivable Turnover Ratio?

As you can see above, what determines a “good” accounts receivable turnover ratio depends on various factors. Holding the reins too tightly 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 properly. It can point to a tighter balance sheet, 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 conservative about extending credit to customers and 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 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 reined in. This can sometimes happen in earnings management, where sales teams extend longer periods of credit to make a sale. 

Ultimately, the time value of money principle implies that the longer a company takes to collect on its credit sales, the less valuable sales are in cash terms. Therefore, a declining AR turnover ratio negatively affects 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. 

Limitations of the Accounts Receivables Turnover Ratio

Like any business metric, there is a limit to the usefulness of the AR turnover ratio. The number must be used within the context of the industry. For example, collecting a payment for office supplies is much easier than collecting receivables 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.

Generally, an AR turnover ratio accurately highlights 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 that any business model that is cyclical or subscription-based may also have a slightly skewed ratio. That’s because the start and end points of the accounts receivable average can change quickly, affecting the ultimate accounts 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:

1. Invoice regularly, promptly, 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 errors.
2. Offer multiple payment methods. Some prefer emails over phone calls. Similarly, they prefer credit cards over checks. The more options you give customers to pay, the faster they will pay you.
3. 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.
4. 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 during the collection process. Be proactive, but don’t annoy people. Internal triggers should activate collection efforts sooner but should never be pushy. That’s how you lose customers.
5. Consider early-payment discounts. Nothing motivates people more than money in business, and offering customers a discount to get cash in the door faster is a standard collection strategy across every industry. Cash payments can also be used to improve the ratio.

Conclusion

The accounts receivable turnover ratio is essential for businesses striving to accelerate their cash flow through excellent company credit policies and accounts receivable management. If businesses don’t collect customer payments on invoices with credit terms promptly, they may experience cash flow issues that affect their ability to pay suppliers on accounts payable invoices when due. 

Delayed receivables can disrupt cash flow and impact supplier payments. Strengthen your AP process with better management strategies—download the AP Survival Guide.