The accounts receivable turnover (AR turnover) is a measure of a company’s effectiveness in collecting payments from its clients and customers. It is calculated using the accounts receivable turnover ratio (AR turnover ratio) and the receivable turnover ratio formula with the values of net sales (net credit sales) and the average accounts receivable. But once you calculate it, how can you know what is a good accounts receivable turnover? How can you assess your company’s performance from the activity ratio value?
In theory, a high turnover ratio is good, and a low turnover ratio is bad. However, in practice, not everything is that black and white.
To truly understand the meaning of your company’s receivables turnover ratio, you need to understand how it fits with the overall performance and how you can effectively compare with other businesses.
It is important to remember that the accounts receivable turnover is different from the asset turnover ratio. The asset ratio represents how well a company utilizes its assets to generate revenue. It has nothing to do with its credit practice or debt collection methods.
High Receivable Turnover
A high turnover rate is characterized by a higher ratio. It means that a company collects payments from its customers relatively quickly, without a long waiting period. A high-efficiency ratio means that the company has high-quality customers who pay their debts in due time. This business likely has little to no trouble managing its cash flow and supporting its advancement.
Businesses that run on a cash basis (for example, grocery stores,) have incredibly high turnovers. That is why the receivable turnover ratio is not a good indicator of the efficiency of their credit policies.
Furthermore, a high turnover doesn’t have to be a good thing. It can also mean that a company is too aggressive with its debt collection and that its credit policies are too strict. They might be losing customers to their competitors that have more favorable credit terms.
Low Receivable Turnover
A low turnover means a low turnover ratio. Manufacturing companies tend to have a low accounts receivables turnover ratio because it takes them a relatively long time to manufacture a product, ship it to their customers, and receive payment.
In theory, a low receivable ratio is a sign of bad debt collecting methods, poor credit policies, or customers that are not creditworthy or financially viable. A company with a low turnover should reassess its collection processes to ensure that all the receivables are paid on time.
If your company’s turnover is low compared to your competitors, it might not be a reflection of your credit policies at all. Perhaps a different part of your business is lacking. Such as your distribution system, for example. If it takes a long time for your product to reach your customers, that may lead to a longer-than-average time for them to pay.
How to Compare the Receivables Turnover Ratio
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.
For a fair assessment of the accounts receivable ratio, it is crucial to compare businesses with the same working capital structures, same payment terms, and within the same industries. Choose competitors that are roughly the same size and preferably have the same business models as your company. That way, you will get an accurate idea of your turnover ratio compared to the industry average.
How to Improve Your Receivables Turnover
If you find that your receivables turnover ratio is low compared to businesses similar to yours, there’s no reason to despair. There are ways to improve it, and here’s how you can do just that:
- 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.
- Strong Customer Relationships
To maintain a high accounts receivables turnover, you need to have strong connections with your customers. Businesses of all sizes benefit from having good customer relationships because happy customers are happy to pay for your goods or services.
Check in with your most loyal consumers. Send them an email, give them a call, or possibly even offer them a discount or a special deal. They won’t risk damaging the relationship they have with your brand by not paying on time.
- 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.
- Software Reminders
It’s impractical to have several different spreadsheets for invoices, outstanding payments, new orders or clients, and similar. Instead, it would be smart to invest in a software solution that will keep everything in one place. It will be easier for you to keep track of everything. You could also set up software reminders, not only reminders for yourself but also regular reminders 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!
- Simpler Billing Structure
A simpler billing structure can eliminate a lot of confusion and panic on the customer’s side. If it is at all possible for your business, try to switch to fixed-fee billing. This means that 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.
The accounts receivable turnover is measured by a financial ratio predictably called the accounts receivable turnover ratio (also known as the debtors turnover ratio). In simple terms, a high account receivables ratio means that your business is doing well in payment collection, while a low ratio means you could improve some things.
However, there are some rules when comparing your ratio to those of your competitors. You need to choose businesses in the same industry as you, roughly the same size, and preferably employ the same business model. Only companies with similar or identical working capital structures can be effectively compared. 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.
If you find that your ratio is not up to par, there are ways you can increase it. Ensure that your invoicing practices are impeccable (that you’re not invoicing late), that you have strong relationships with your customers, and that they are clear on the payment terms and conditions before they sign any agreements or contracts. Furthermore, consider simplifying your billing structure (switching to fixed-fee billing) and perhaps finding a software solution that will remind you of your billing responsibilities.
Consero Global offers financial solutions for any business. Reach out to us if you’d like some help with your receivables management and improving your account receivable ratio. We’d be happy to answer any questions you may have on this topic!