Accounts Receivable Turnover Ratio: An Essential Financial Metric

 A higher ratio denotes superior management of customer credit. From evaluating credit and collection efficiency to influencing cash flow management, mastery of the accounts receivable turnover ratio is paramount for any business proprietor.

In this article, we aim to elucidate this pivotal ratio, elucidating its computation, interpretation, and strategic ramifications.

Key Highlights

• The article highlights the significance of the accounts receivable turnover ratio, highlighting its role in assessing a company's efficiency in managing client payments and credit procedures. 
• It explains the calculation process, including determining net sales made on credit and calculating the average accounts receivable. 
• The article also discusses strategies to improve the turnover ratio, such as precise invoicing, outsourcing accounts receivable, etc.

Accounts Receivable Turnover Ratio Calculation

If accounting and finance weren't your strong suits during your academic years and you're encountering this ratio for the first time, there's no need to worry. The formula for the accounts receivable turnover ratio isn't complicated. You can manage it!

Determine Your Net Sales Made on Credit

Net credit sales denote the revenue generated from credit sales after deducting returns and allowances. The formula is as follows:

Net credit sales = Annual credit sales - (Sales returns + Sales allowances).

You can find the necessary figures for this formula in your yearly income statement or balance sheet.

Calculate the Average Accounts Receivable

The average accounts receivable measures the mean value of outstanding invoices settled within a specified period. To calculate this, you add the starting and ending receivable amounts for the period (typically months or quarters) and then divide the total by two.

Calculate Your Accounts Receivable Turnover Ratio

To determine your receivables turnover ratio, divide your net credit sales (from Step 1) by your average accounts receivable (from Step 2). The formula is as follows:

Accounts receivable turnover ratio = (Net credit sales) / (Average accounts receivable)

For effective monitoring of trends and patterns, calculate this ratio quarterly.

Accounts Receivable Turnover Ratio Calculations Examples

Let's examine the financial performance of Company X over the past year:

• The company recorded net credit sales of $700,000.
• At the start of the year, on January 1st, accounts receivable stood at $54,000.
• By the end of the year, on December 31st, accounts receivable had increased to $62,000.

To calculate the receivables turnover ratio, we determine the average accounts receivable, which is obtained by adding the beginning and ending receivable amounts and dividing the total by two. In this case, the average accounts receivable is calculated as follows:

Average accounts receivable = ($54,000 + $62,000) / 2 = $58,000

Subsequently, the accounts receivable turnover ratio is calculated by dividing the net credit sales by the average accounts receivable:

Accounts receivable turnover ratio = $700,000 / $58,000 = 12

This ratio signifies that Company X converted its receivables into cash an average of 12 times throughout the year. By comparing this figure across multiple years, the company can assess whether this represents an improvement or a slowdown in the collection process.

Additionally, companies can determine the average duration of accounts receivable, or the number of days it takes to collect them annually. Using the provided example, dividing 365 by 12 yields an average duration of approximately 30.4 days. Therefore, on average, customers of Company X take 30 days to settle their receivables.

Now, let's consider another scenario:

Imagine your company achieved net credit sales of $300,000 for the year, with an average accounts receivable of $50,000. By dividing the net credit sales ($300,000) by the average accounts receivable ($50,000), the resulting ratio is six:

$300,000 (net credit sales) / $50,000 (average accounts receivable) = 6 (accounts receivable turnover ratio)

This ratio of six indicates that your business collects average receivables six times annually.

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How to Interpret the Ratio?

Assessing whether your accounts receivable turnover ratio is considered "good" can be complex, depending on various factors. Industry payment terms, your credit policies, economic conditions, and customer behaviour all significantly influence the ratio. 

Therefore, when evaluating the ratio results, it's crucial to consider these contextual factors.

High A/R Turnover Ratio Vs. Low A/R Turnover Ratio

A high receivables turnover ratio suggests efficient account collection and a client base known for prompt payments, possibly indicating a cash-centric operational model. Moreover, it may imply conservative credit extension practices, which are advantageous for averting credit risks with potentially delinquent customers.

However, excessively conservative credit policies could dissuade prospective customers, prompting them to seek competitors with more flexible credit terms. To avert client loss or hindered growth, companies might relax their credit policies to bolster sales, even if it results in a reduced accounts receivable turnover ratio.

Conversely, a low receivables turnover ratio suggests potential issues like ineffective collection processes, flawed credit policies, or financially unstable customers. Re-evaluating credit policies can aid in enhancing timely receivables collection. Nevertheless, improving the collection process for a company with a low ratio could lead to an infusion of cash from overdue receivables.

Low ratios aren't invariably negative. For example, inefficiencies in a distribution division might cause delayed deliveries, prompting customers to defer payments and diminishing the company’s receivables turnover ratio.

When Accounts Receivable Turnover Ratio is Used?

The accounts receivable turnover ratio is primarily used to measure a company's ability to handle extended credit, providing insights into the effectiveness of its AR practices and areas for enhancement.

The debtor’s turnover ratio reveals the efficiency of their collection procedures and highlights necessary actions to recover overdue payments. A higher days sales outstanding (DSO) reduces a business owner's available working capital, accentuating the impact of inadequate AR management on accounts payable operations.

To assess AR efficiency, the receivable turnover formula should be applied at regular intervals, typically monthly, quarterly, and yearly. It can be computed overall or on a client-specific basis to identify delinquent clients and their payment patterns.

How to Improve Turnover Ratio?

A low AR turnover ratio suggests adjusting credit and collection policies is necessary. Here are 6 actions you can take to enhance your ratio:

• Regular and precise invoicing is crucial. Timely invoicing ensures prompt payments. Accounting software automates tasks and minimises errors, aiding in efficient invoicing.
• By outsourcing accounts receivable, companies can concentrate on core goals while professionals oversee payment management comprehensively.
• Always clarify payment terms in contracts, invoices, and client communications to avoid surprises and ensure timely payments.
• Provide various payment options to accommodate diverse preferences. This ensures convenience for customers, enhancing timely payments.
• Set follow-up reminders to avoid delays in collection procedures. Implement internal triggers for early escalation or a dunning process to ensure timely collections.
• Offer cash discounts to incentivise prepayments, reducing AR costs and improving the ratio.

 Improve Your Accounts Receivable Turnover Ratio With OAR

Author: Giles Goodman, Commercial Intervention Officer OAR
Giles Goodman is the definitive expert in cross-border commercial debt collection, mediation, legal recovery, and accounts receivable. Based in London, his 25 years of experience provide a global perspective on preventing defaults and efficiently managing overdue accounts. Giles’s insights and analyses empower business owners worldwide with strategic approaches to financial management and recovery.

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