A good finance & accounting operation is at the heart of every successful business. It would be best to hire a professional Finance as a Service partner to handle your finances, especially if you are running a sizable organization. However, you should also be familiar with at least the basics of finance & accounting so that you can understand what is happening to your business’ budget. One of the fundamental questions is: what is the accounts receivable turnover formula?
To know how to use this formula and what it represents, you also need to learn about the accounts receivable turnover (AR turnover) and the accounts receivable turnover ratio (AR turnover ratio). These sound like complex terms that you may not have heard of before, but they’re not too difficult to understand once they’re broken down.
Let’s start from the beginning.
Accounts Receivable Turnover
The accounts receivable turnover describes how well a company collects its revenue.
Receivable refers to the money owed to the company by its customers or clients. Basically, the receivable turnover reflects how good a company is at collecting payments. It is calculated using the accounts receivable turnover ratio.
Accounts Receivable Turnover Ratio
The receivable turnover ratio is a measure derived from the receivables turnover. The turnover ratio is used in accounting to determine the efficiency of a business – it is also called the debtor’s turnover ratio or an efficiency ratio.
A high turnover ratio typically means that the company has many quality customers who pay their debts in due time. The company’s collection of account receivables is efficient.
In contrast, a low turnover ratio indicates that the company might have poor credit policies, a bad debt collection method, or that their customers aren’t creditworthy or financially viable.
How to Calculate the Accounts Receivable Turnover?
The accounts receivables turnover is calculated using the account receivables turnover ratio.
The receivables turnover ratio formula is as follows:
Net Credit Sales / Average Accounts Receivable = Accounts Receivables Turnover
The average accounts receivable is calculated according to this formula:
(Beginning Accounts Receivables + Ending Accounts Receivables) / 2 = Average Accounts Receivable
The time period you choose to calculate the turnover for is entirely up to you. Typically, organizations like to calculate the accounts receivable turnover ratio for the past 12 months.
These operations might seem too confusing when presented as dry formulas like this. Indeed, you probably aren’t sure how to calculate the average accounts receivable, let alone the turnover. To better explain how the receivable ratio works and how you can find the ratio for your organization, here is an example:
Company XYZ earned $950,000 in net sales over the past 12 months. On January 1st, their receivables were $70,000 (beginning accounts receivables). On December 31st, their receivables were $81,000 (ending accounts receivables).
This is their average accounts receivable:
($70,000 + $81,000) / 2 = $75,500
Their accounts receivables turnover ratio is then:
$950,000 / $75, 500 = 12.58
The conclusion is that for the company XYZ, the accounts receivable turned over 12.58 times in the last year. If we want to extract useful information out of this, we have to calculate the accounts receivable turnover in days according to this formula:
365 / Accounts Receivables Turnover Ratio = Accounts Receivables Turnover Ratio in Days
For XYZ, this means:
365 / 12.58 = 29.01
The average account receivable was collected in approximately 29 days. It means that it takes, on average, 29 days for the company to collect payment from its customers or clients. Whether this is good or bad for the company requires comparing the result to previous years and analyzing the financial statements.
Receivables Turnover vs. Asset Turnover
The accounts receivables turnover and asset turnover are often considered to be one and the same. However, there are slight differences between these two terms that shouldn’t be mixed.
The asset turnover ratio describes how well a company uses its assets to generate revenue – the emphasis being on generate. Investors can use this turnover to compare companies within the same sector or group. The asset turnover is impacted by significant asset purchases or large asset sales within a defined accounting period (usually a year).
In comparison, the receivables turnover is all about collecting money. The asset turnover ratio measures how well the company utilizes its assets, while the account receivable turnover ratio describes how it manages the credit it extends to its customers.
Importance of the Accounts Receivable Turnover
As mentioned above, the general rule of thumb is that a high receivable turnover is good, while a low one is bad. However, this doesn’t always have to be the case – different conditions have to be taken into account for each company.
For example, grocery stores typically have high turnover rates because they get almost instant payments from their customers. In such cash-heavy businesses, the AR turnover is not a good measure of how they are managed.
In the same vein, manufacturing businesses tend to have a low turnover rate because the payment terms are different. The time that passes until payment is collected is a lot longer than in the case of a grocery store.
The accounts receivable turnover allows organizations insight into how quickly they collect their payments. This information is essential when the organization plans its future investments and even pays its bills and expenses on time.
Secondly, the receivable turnover ratio can point at faults in the organization’s credit policies. It is a valuable tool in determining whether all the processes support good cash flow and business growth.
Another important point to emphasize is that even if you have a favorable turnover ratio, it does not tell you whether some of your customers are on the path to bankruptcy or considering leaving you for a competitor. The ratio is about overall customer trends, meaning it can’t pinpoint individuals to tell you who your best and worst customers are.
Tracking the Receivable Turnover
It is not enough to simply calculate the turnover each year and observe it as an isolated occurrence. To keep track of your company’s performance and efficiency, you need to monitor the receivable turnover over time. It will help you recognize opportunities for improvement in your credit policies.
Tracking the accounts receivable turnover also has the following benefits:
- Improving your collection processes
- Forecasting your future cash flow
- Getting a bank loan – Bankers will want to see your receivable turnover so they can determine the bank’s risk in approving you for a loan. The accounts receivables are often used as collateral. Generally speaking, the higher your turnover ratio, the better your chances are of obtaining a loan.
Look for patterns in your turnover that emerge over time. They will reveal the impact of your company’s credit practices on its profitability.
Furthermore, as mentioned above, investors can use the receivable turnover to get a sense of an average account receivable turnover for a specific sector or industry. If an organization has a higher turnover than the average, it might prove to be a safer investment. Again, it all depends on the bigger picture and how the turnover value fits into the overall performance of the company.
Conclusion: The Big Picture
The accounts receivable turnover describes the efficiency of a company in collecting payments. It is different from asset turnover, which describes how a company uses its assets to generate revenue. The receivables turnover is calculated by using the formula for the accounts receivable turnover ratio.
The most significant aspect of the accounts receivable turnover is that it cannot tell you much by itself. If it is high, it could be because your company is running on a cash basis, or you have high-quality customers who pay on time. However, it could also mean that maybe your collection practices are aggressive or you are too conservative about extending credit to your customers.
The same goes for a low turnover. It doesn’t have to mean that your company is operating poorly – just that the nature of your business requires a longer time to collect payment.
It is important to compare your receivables turnover with the turnover of your competitors. Additionally, tracking the pattern of your turnover over time will help you determine your business’s performance.
If you have any questions about the accounts receivable turnover or would like some help with calculating yours, don’t hesitate to contact Consero. We would be happy to lend you a hand and alleviate some of the stress of managing your receivables. Reach out for a free demo if you’d like to see what we can do for you!