Accounting is essential for any business, no matter how big or small. Some company executives have in-house accountants to handle their finances, while others outsource those services. Nevertheless, even if you are not accounting-savvy yourself, you should be familiar with at least the basic accounting concepts. One of those is the accounts receivable turnover or AR turnover.
At first glance, AR turnover seems like a complex thing. There are special formulas used to calculate it and guidelines that dictate how you should compare your turnover to your competitors.
The ultimate guide to accounts receivable turnover in 2021 will introduce you to the basics of this business metric and how you can use it to improve your balance sheet. Read on to learn the definition of the accounts receivables turnover, the receivables turnover ratio, how you can calculate it, and what it means for the performance of your organization.
What is Accounts Receivable Turnover?
The accounts receivable turnover is a measure of how well a business collects its revenue. Receivable is used to describe the money or payments owed to the business by its clients or customers. Theoretically, if a company is efficient in collecting its receivables, it has a high turnover rate. If it’s not so efficient, it has a low turnover rate.
The receivable turnover is calculated using the accounts receivable turnover formula for the accounts receivable turnover ratio (AR turnover ratio or ART ratio).
Accounts Receivable Turnover Ratio
The receivable turnover ratio is an efficiency ratio that reflects the receivable turnover. It can also be called the debtors turnover ratio.
The receivable turnover ratio is different from the asset turnover ratio. The former describes how well a company collects its payments, while the latter describes how well a company utilizes its assets to generate revenue. The key difference here is between the words collect and generate.
The receivables turnover ratio can be found through the receivable turnover ratio formula:
Net Sales / Average Accounts Receivable = Account Receivable Turnover Ratio
Net sales can also be called net credit sales.
The average accounts receivable (average AR) for a specific time period is calculated like this:
(Beginning Accounts Receivables + Ending Accounts Receivables) / 2 = Average Accounts Receivable
You can choose what you want the average collection period to be – a month, a quarter, or a year.
Receivable Turnover Ratio Example
Here is an example based on a fictional company named ABC to help you better understand how to use these formulas.
First, let’s calculate the average accounts receivable for an entire year at ABC. Their receivables on January 1st were $81,000. These are beginning accounts receivables. Their receivables on December 31st were $90,000. These are ending accounts receivables. So the average accounts receivable is as follows:
(81,000 + 90,000) / 2 = 85,500
Their net sales during the year were $930,000. Their turnover ratio was:
930,000 / 85,500 = 10.88
According to this result, ABC’s accounts receivable turned over 10.88 times in twelve months. We can use another formula to extract useful information from this:
365 / Accounts Receivables Turnover Ratio = Accounts Receivables Turnover Ratio in Days
In this case, the receivable turnover ratio in days is:
365 / 10.88 = 33.55
The conclusion is that it takes an average of 33.5 days for the ABC company to collect payment from its customers. When observing this number by itself, it doesn’t tell us much. Only when we compare this ratio with that of other companies can we get an idea of how well ABC operates.
What is a Good Receivables Turnover?
In the most general sense, a low receivables turnover is bad, and a high turnover is good. However, these two distinctions require a more detailed analysis.
- Low Turnover Ratio
Typically, a low turnover ratio means that a business has bad debt collection practices and poor credit policies. It could also mean that its customers are not financially viable enough to settle their dues on time.
However, companies that take longer to manufacture a product and deliver it to their customers have a naturally low receivables turnover.
Furthermore, if your ratio is low, it might not have anything to do with your payment collecting practices. A different part of your business could be in trouble, such as your production process being too slow or your distribution system not managing to deliver your products on time.
- High Turnover Ratio
Opposite to the low ratio, a higher ratio usually points to good credit policies, high-quality customers with enough money to pay on time, and a short waiting period between invoicing and payment. Companies with high turnover ratios have a good cash flow that can easily support their business growth.
On the other hand, it may not be that clear-cut. A high turnover rate is expected for businesses that operate on a cash basis (for example, grocery stores), meaning that this ratio is not an accurate measure of their efficiency.
A high ratio can also result from a company’s conservative credit policies or aggressive debt collection methods. Without even knowing about it, an organization may be losing customers to their rivals who have better credit terms.
Comparing Receivable Turnovers
A CEO or CFO of a company will want to know how their business is performing compared to their competitors. Investors, likewise, want to know the receivables turnover so they can gauge whether a company is worth investing in.
When comparing turnovers, you must know how to do it properly. You cannot simply take any company that you perceive as successful and evaluate your business against it. Specific guidelines have to be followed so that you don’t reach the wrong conclusion.
First and foremost, only businesses within the same industry should be stacked against each other. There is no point in comparing retail stores to manufacturing businesses when they have vastly different capital structures.
Ideally, you should compare your turnover with companies in the same industry as you, the same approximate size, and preferably have the same business model. Any deviation from this might result in a skewed comparison that will leave you thinking your AR turnover is higher or lower than it really is.
Limitations of the Receivables Ratio
When comparing the accounts receivable ratio of an organization to other companies, you need to consider several limitations.
- Net Sales vs. Total Sales
In the formula for the receivable turnover ratio, the value of net credit sales is used. However, some companies use the value of total sales instead.
Total sales (gross sales) is sales revenue before discounts or returns. Net sales are the result of subtracting deductions (refunds, returns, etc.) from total sales.
Those who use total sales when calculating their receivables ratio most likely don’t intend to be misleading – it’s probably just the way they do their accounting. Keep in mind that these results are more inflated compared to ART ratios calculated via net sales.
If you’re an investor looking for a good opportunity, make sure you inquire how an organization calculates its accounts receivable ratio before making any decisions based on that.
- Context Required
Unfortunately, once you have the ratio number in front of you, you cannot glean much from it unless you put it into context. To effectively compare it with other companies, you should follow the guidelines outlined above.
If you find that your ratio is higher than average, you need to ensure this isn’t due to strict credit policies. Additionally, if your ratio is lower than average, it might not have anything to do with collecting payment. Thoroughly assess every aspect of your business to find out why exactly your receivables turnover is lower than it should be. Are your customers on the verge of bankruptcy? Are they leaving your business for a competitor?
To accurately draw conclusions from your AR turnover ratio, you must observe it as part of a bigger picture. Context is crucial.
- Seasonal Companies
The receivables turnover of seasonal companies can vary drastically throughout the year. These businesses operate at full capacity during specific times of the year, while in others, they close down entirely or massively scale down their operations.
It isn’t uncommon for seasonal companies to have lower turnovers in their peak seasons when it is more challenging to keep track of all the orders, customers, and payments. They could have much higher turnover ratios during their off-seasons when they have more time dedicated to collecting dues.
If you’re intent on investing in a seasonal company, you should carefully select a time period for which to calculate their ratio. This period should accurately reflect the company’s effectiveness in collecting the debt. Potential seasonal gaps can be evened out by calculating the average receivable for every month in a single year.
How to Improve Your Receivables Turnover
You’ve done everything right – double-checked the formula for the turnover ratio and compared it to businesses similar to yours – and now you’re faced with a low turnover rate. Your company isn’t doing as well as you want it to. Now what?
There are several ways you can improve your receivables turnover. Here are some of the most effective suggestions:
- Regular Invoicing
Every invoice you send out should be detailed and accurate. It will save your customers from having to deduce what’s what and strictly how much they’re required to pay. A clear, understandable invoice saves time and helps you receive your money faster.
Do your best never to miss your invoice date, if there is one. If there isn’t, you should send your bill the moment the work or service is completed. Sending invoices late could be another reason you’re not getting paid on time – you’re simply not giving your customers a chance.
Moreover, it is better to regularly invoice smaller costs than wait for them to pile up. Psychologically speaking, customers will have an easier time paying for several bills for lower amounts than one bill for a vast amount. Besides, if you wait too long to send the total bill, they might already mentally move on and be unpleasantly surprised with the price at the end.
- Software Reminders
Another method to improve your turnover can be tied to the first bullet point – having accounts receivable software that reminds you when invoices are due to be sent out. Instead of managing multiple documents for outstanding invoices, new orders, clients waiting for their product, financial statements, etc., you could have it all neatly organized in one software package.
You won’t have to worry whether or not you sent a bill on time. If it is designed right, you can also use the software to send automatic reminders to customers before the deadline on their invoices runs out!
- Clear Payment Terms
Before your customers sign any agreements, they need to have a clear understanding of payment terms. If the moment comes when you must enforce strict policies, you cannot hope to do that if you haven’t disclosed them to your customer first. All forms of communication (invoices, agreements, and contracts) must clearly outline your customers’ duties regarding payment.
Standard practice is to implement a 30-day payment deadline. If your customer doesn’t pay their dues in 30 days from the moment they receive their invoice, you can include extra charges for late payments. Similarly, if a customer is a valuable one – paying more money than usual – you can negotiate better credit terms or payment plans that will benefit you both.
- Strong Customer Relationships
Customer relationships based on trust and positive emotions have numerous benefits. These people are loyal followers of your brand and will return for more purchases. They will spread the word about your business, products, or services to their family and friends, or even better – on social media. And lastly, they will be more inclined to quickly pay their debts to you, not to jeopardize the good relationship they have with your business.
To build a strong relationship with your customers, check in with them from time to time. See who your most loyal consumers are, send them an email, or perhaps give them a call. You could even offer them a discount or a special deal for their loyalty to your brand.
- Simpler Billing Structure
Finally, many companies get lost in the number of customers they have and bills they need to keep track of every month. Even with an efficient software solution, errors can happen.
If it is possible for your company, try moving onto a more straightforward billing system, such as fixed-fee billing. Essentially, your customers will be on a fixed monthly subscription for which they will be getting a previously-agreed upon service or product. Most SaaS (software as a service) platforms function this way.
Fixed billing ensures that customers aren’t surprised by unexpected costs (since they will be paying the same amount each month), and it also offers you the chance to withdraw funds directly from their accounts. With fixed-fee billing, there is no waiting period between invoice and payment – on a specific date, your company charges your clients with their fee, and everyone’s happy!
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.
The accounts receivable turnover is a valuable measure in any accounting system. This value is calculated using the accounts receivable turnover ratio that tells the company’s executives or potential investors how efficiently the company collects its payments (receivables). If the turnover ratio is high, typically, the business has little to no problems collecting payments from its customers. If the ratio is low, there could be room for improvement.
When comparing the receivables ratio of two or more companies, you must keep in mind that these companies should be as similar as possible. They should be from the same industry and of a similar size and business model. It would be best to consider differences in turnover between different seasons of seasonal businesses and whether a company uses its total sales or net sales value to calculate the turnover ratio.
If you find that your turnover isn’t satisfactory, there are ways you can improve it. You could implement a software system to remind you and your customers of when payment is due. You could enhance your invoicing so that it is more regular and detailed. Building solid relationships with your customers and clearly communicating the payment terms to them also lead to a higher turnover rate.
Accounts receivable management is not too complicated when broken down, but it does require time and effort. If you’d like some help or have any questions about the receivables turnover of your business, don’t hesitate to contact Consero Global. We would be happy to assist you in improving your receivable balance as much as possible!