The accounts receivable turnover ratio indicates how many times the accounts receivables have been collected during an accounting period. Businesses and investors use the AR turnover formula to measure how efficient a company is in collecting sales made on credit to finance its operations.
The higher the turnover, the faster the business is collecting its receivables. It can be expressed in many forms including accounts receivable turnover rate, accounts receivable turnover in days, accounts receivable turnover average, and more.
Meaning
Also known as the debtor’s turnover ratio, AR turnover measures how efficiently a company collects money owed from their customers or clients and manages its line of credit process.
It is an important indicator of a company’s operational and financial performance. A company with a higher accounts receivable turnover ratio could be considered more efficient than an industry peer with a lower ratio.
High Ratios
A high turnover rate has a higher ratio, meaning that a company collects payments from its customers relatively quickly without a long waiting period.
A high accounts receivable turnover ratio could indicate a few things:
- An efficient business operation, where the business is unlikely to struggle managing its cash flow to support future growth
- The business runs on tight credit policies
- The business has quality customers who pay their debts quickly
- The business operates on a cash basis (ex. grocery stores)
However, a high AR turnover ratio alone is not enough to determine if a business is well-run, or how efficient it is with credit policies.
It could also indicate the company is too aggressive with its debt collection, too strict with credit policies or losing customers to competitors that offer more favorable credit terms.
Low Ratios
A low turnover rate will have a low turnover ratio, meaning a company takes longer to receive payments owed from customers. A low or declining accounts receivable turnover could signal a business has:
- Problems collecting from its customers
- Poor or too lenient credit policies
- Too many customers that are not creditworthy or financially viable
However, low ratios don’t always indicate deficient credit policies. For example, manufacturing companies usually have a low accounts receivables turnover ratio because it takes them a relatively long time to manufacture a product, ship it to customers, and receive payment.
If a company’s turnover is low compared to competitors, another part of the business may be the culprit. For example, if it takes a long time for product to reach customers, that may lead to a longer-than-average time for them to pay.
How It’s Used
The accounts receivable turnover ratio is important for CEOs and CFOs in evaluating their company’s efficiency, payment collection processes, and credit policies. It is also valuable for investors to assess a company’s performance and whether it represents a good investment.
Many companies live and die by collections. These rates are essential to having the necessary cash to cover expenses like inventory, payroll, warehousing, distribution, and more.
Companies use the AR turnover ratio to calculate whether the payments they’re collecting are enough to cover their expenses and finance their future operations. Businesses commonly have an accounts receivable allowance to prevent cash flow issues.
If you don’t know your receivables turnover, you won’t be able to determine whether your credit policies are good or bad or whether your cash flow supports your business’s advancement.
Accounts Receivable Turnover Formula
The accounts receivable turnover formula is based on net or annual sales and average account receivables. The formula can be expressed as:
- Net Credit Sales / Average Account Receivables = Accounts Receivables Turnover Ratio
- Accounts Receivable Turnover = Annual credit sales / Average accounts receivable
The average account receivables is calculated like this:
(Starting Receivables + Ending Receivables) / 2 = Average Account Receivable
Sales are calculated as sales returns, sales allowances, or sales on credit. The average accounts receivable is calculated based on the beginning and ending receivables over an average collection period (a month, a quarter, or a year).
A profitable accounts receivable turnover ratio formula creates survival and success in business. Phrased simply, an accounts receivable turnover increase means a company is more effectively processing credit. An accounts receivable turnover decrease means a company is seeing more delinquent clients.
Calculation
Using Net Sales: To better illustrate how you can use net sales can be used to calculate the receivable ratio, let’s use an example of a company named XYZ.
- XYZ had net credit sales of $3,500,000 in the last 12 months.
- At the beginning of this period, they had a starting accounts receivable balance of $320,000.
- At the end of the period, they had a balance of $400,000.
Step 1: We calculate the average accounts receivable:
($320,000 + $400,000) / 2 = $360,000
Step 2: We determine the receivables turnover ratio:
$3,500,000 / $360,000 = 9.72
The account receivable turnover ratio for XYZ in the past year is 9.72.
It doesn’t seem high, but whether this is good or bad for XYZ can be determined only by taking into account the industry this company works in and the turnover ratios of its competitors.
Using Total Sales: In practice, it can be hard to get the number of how much of the sales were made on credit. Investors can use total sales as a shortcut. When this is done, it is important to remain consistent if the ratio is compared to that of other companies.
Example:
- Assume annual credit sales are $10,000
- Accounts receivable at the beginning of the year is $2,500
- Accounts receivable at the end of the year is $1,500.
The accounts receivable turnover is: 10,000 / ((2,500 + 1,500)/2) = 5 times.
Examples
Manufactco is a company that manufactures popular widgets. The company is growing quickly and must hire new employees for their plant, but need to ensure they are collecting enough cash for expansion. Here’s how they can use their current accounts receivable turnover rate to adjust their operations:
- Annual Credit Sales: $10,000
- Accounts Receivable in 1/1/24: $2,500
- Accounts Receivable in 12/31/24: $1,500
Currently, Manufactco’s accounts receivable turnover rate is: $10,000/ (($2,500 + $1,500)/2) = 5 times.
In this example, a full turnover happens 5 times in one year, meaning that in a full year all open accounts receivable are collected and closed 5 times.
Now let’s make things a bit more complicated. How many accounts receivable turnover days will it take to complete one cycle?
Simply use this formula:
Days Receivable Outstanding = # of days / accounts receivable ratio calculation
The period for this example begins at 1/1/24 and ends at 12/31/24, so the number of days for this period is 365. Manufactco’s accounts receivable equation for the number of days a receivable is outstanding is:
365 days / 5 times = 73 days for AR to turnover
This means that all open accounts receivable are collected and closed every 73 days. In 73 days customers make a purchase, are reminded that payment is due, send payment, have payments processed, and have receivable accounts closed.
The Chief Financial Officer of Manufactco now knows that 5 full turnovers happen in a year. She also knows that it takes 73 days for one full turnover to occur. Creating a profitable company is now a simple matter.
Tightening credit policies is one common method. Options include:
- Decreasing the amount of days allotted before payment is due
- Including or increasing discounts for early payment
- Increasing the late payment penalty fee.
Additionally, she could update collections technologies or simply increase collections staff. In extreme conditions, Manufactco could even stop serving certain customers, in effect “firing” those who are late or non-paying.
Limitations
The accounts receivable turnover ratio should be used for “apples-to-apples” comparisons for time periods or different companies within the same industry. Certain industries will tend to have higher or lower ratios based on the nature of the business, because the faster a company gets paid by their customers for a product or service, the higher the ratio is.
For example, grocery stores tend to have high turnover ratios because they operate on a cash basis – their customers pay for their products almost instantly. Likewise, manufacturing companies typically have a low ratio because it takes a longer time to produce their goods, ship them to the customers, and get paid for them.
More Context Needed
By itself, the ratio doesn’t paint the full picture about an organization and how it is financially managed. It also doesn’t predict whether its customers are on their way to bankruptcy or perhaps leaving the company for a rival.
A low turnover ratio might not have anything to do with bad debt (credit) policies. There might be a problem in the organization’s distribution system. Their goods aren’t getting delivered on time, and therefore customers aren’t paying promptly, either.
Furthermore, a high turnover rate isn’t necessarily a reflection of good business. It could point to conservative credit-issuing policies or aggressive payment collecting methods. It is also difficult to gauge the effectiveness of a business that runs on a cash basis.
To properly understand the value of the accounts receivables turnover ratio, you must add context to it. It should be just one of the elements to look at when assessing a company’s performance.
Comparing Different Capital Structures
Even within the same industry, the AR turnover ratio is best used to compare companies of similar size and business model. Comparing businesses with different capital structures can skew any conclusions drawn from turnover calculations.
A company with a high level of debt may have stricter credit policies to ensure faster collection of receivables to maintain liquidity for debt servicing. The accounts receivable turnover would appear higher compared to a company with less financial pressure.
Alternatively, a business with low or no debt may adopt more lenient credit terms to attract customers, leading to a lower turnover ratio.
Seasonal Businesses
Accounts receivable can also fluctuate throughout the year, particularly for seasonal businesses. Such companies may have periods of high receivables (and low turnover ratios), and periods with fewer receivables that are more quickly collected.
The beginning and ending time periods used to calculate the average accounts receivable should be consistent to accurately measure the company’s performance. For example, investors can compare the average accounts receivable for a 12-month period compared to the previous year to account for seasonal gaps.
Total Sales vs. Net Credit Sales
Gross or total sales is the total sales revenue before any returns or discounts. Net sales are the result of subtracting returns, refunds, or any deductions from total sales. If total sales is used instead of net sales, the ratio will appear higher.
Investors should also be aware of how businesses calculate the ratio, as some may use different accounting metrics. Not all companies use their net sales value to calculate the receivable turnover ratio. Some use their gross (total) credit sales instead.
Companies that use total sales likely don’t do it to be misleading or present an inflated ratio – rather, that is probably just how they do their business.
How to Compare Ratios
If you want to get a fair assessment of how a company is doing or whether their ART ratio is high or low, you need to compare companies in the same industry, roughly of the same size, and, preferably, that have the same business models. Anything else might give you a skewed picture of the company’s status.
It would be best to find the average receivable turnover for your sector and then evaluate where your company’s ratio stands in comparison to it.
Comparing the ratios of two different businesses does not make much sense. If you put up an average grocery store against a car part manufacturer, you will get vastly different ratios that will likely lead you to the wrong conclusions.
Companies of different sizes have different working capital structures and payment terms that influence their turnover ratios. The same goes for companies that operate in different industries.
How to Improve Your Receivables Turnover
If you find that your receivables turnover ratio is low compared to businesses similar to yours, there are practical ways to improve it.
Maintain Accurate and Regular Invoicing
Make sure that all of the invoices you send out are accurate and detailed. When everything is neatly laid out on paper, it will be much easier for your customers to understand what the bill says and what amount is required for them to pay.
If there is a set date for invoicing, don’t miss it. If there isn’t, send your bill the moment the work is completed or delivered. If you send in your invoices late, you risk setting a standard for late payments for your customers.
Furthermore, do not wait for the outstanding costs to pile up before you invoice a client. If more than a month passes between the finished work and the invoice, your customers have already mentally moved on. It is also more sensible for them to pay regular smaller bills than one large bill at the end of a quarter.
If your accounting department is small or overwhelmed, outsourcing your invoicing to a capable F&A partner is an efficient way to both ensure accurate invoicing and lowering the burden on your in-house staff.
Set Clear Payment Terms
When it’s time to collect your payment, you cannot hope to enforce policies or agreements you never disclosed to your customer. Therefore, you must be clear about the payment terms of your company upfront. Ensure that all communication with your customer (agreements, contracts, and invoices) state what their duties are in terms of payment.
A common restriction is giving a 30-day deadline for the payment (from the moment you send out the invoice). Don’t hesitate to include charges for late payments if your customers go over the 30-day limit. If you sell a product or service for a higher dollar value, you can implement payment plans or set credit limits that will work for you and your customer.
Use Software Reminders
It’s impractical to have several different spreadsheets for invoices, outstanding payments, new orders or clients, and similar. For example, businesses that started using QuickBooks and Excel can quickly run into trouble as they scale.
Investing in a cloud-based software solution like Consero’s Simpl platform keeps everything in one place. It will be easier for you to keep track of everything. You could also set up software reminders for yourself and for your customers that their payment is due.
You won’t have to worry about remembering whether you sent an invoice on time or whether the customer paid on time because your software solution will do everything for you.
Simplify the Billing Structure
A simpler billing structure can eliminate a lot of confusion and panic on the customer’s side, such as switching to fixed-fee billing. Every month (or at agreed intervals), the customer pays a fixed price for your product or service. Fixed-free billing goes a long way in ensuring that you don’t get calls from customers wondering why their bill is higher than expected.
Additionally, with this billing structure, you could arrange to withdraw payments from your clients’ accounts every month automatically. You won’t have to send them an invoice and wait for them to pay, which should increase your receivable turnover rate.
Tracking Your Receivable Turnover
Just as you cannot infer much from the turnover value alone, you also cannot make predictions of your company’s profitability or efficiency if you don’t keep track of the turnover over time. It will help you forecast your future cash flow, plan for future investments, or even get a bank loan! Banks often use the account receivable as collateral when approving a loan.
When tracking your receivables turnover, search for patterns that emerge over time. They will clearly showcase how your credit policies are affecting your company’s performance in the long run.
Streamline Your AR Turnover with an Outsourcing Partner
The accounts receivable turnover ratio is a decent measure of a company’s credit policies and its efficiency in collecting payments, but this shouldn’t be used alone to determine the health and efficiency of a company.
To understand how a company is managed on a bigger scale, you will need more information than only the turnover value.
If your AR/AP process is not up to par, you can turn to a finance and accounting expert like Consero to improve it. Our proven Finance as a Service (FaaS) model provides the systems, processes, and people to quickly automate your AR process and ensure that your invoicing practices are impeccable with our AI-enabled solution.
We also have the expertise to work within your existing system and general ledger. Through Consero’s FlexFinance service, we can manage the back-office F&A function from end-to-end process, including closing the books. If you need skilled talent to manage your AR, we can supplement your F&A team via our FlexResources.
Reach out to us if you’d like some help with your receivables management and improving your account receivable ratio.
