How do companies measure their efficiency? How can they calculate whether the payments they’re collecting are enough to cover their expenses and finance their future operations? Answers to these questions are multifold, but they all boil down to one fundamental value – the accounts receivable turnover ratio (AR turnover ratio).
The accounts receivable turnover (AR turnover) can tell a CFO or a CEO how efficient their organization is in collecting money from their customers or clients. 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.
So, what is the accounts receivable turnover ratio?
It may sound complicated, but calculating it is actually not difficult at all.
What the Accounts Receivable Turnover Ratio Measures
The AR turnover ratio or the debtors turnover ratio is an efficiency ratio – it is a measure of a company’s effectiveness in collecting payments. The accounts receivable refers to the money owed to the company by its customers or clients.
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 incredibly 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.
To calculate the turnover ratio for your business, you will need to understand a couple of formulas and properly implement them in your budget calculations.
The Receivable Turnover Ratio Formula
The formula for the receivable turnover ratio is based on net sales and average account receivables. The net 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).
The primary formula looks like this:
Net Credit Sales / Average Account Receivables = Accounts Receivables Turnover Ratio
As mentioned above, the average account receivables section of the main formula is calculated like this:
(Starting Receivables + Ending Receivables) / 2 = Average Account Receivable
To better illustrate how you can use these formulas 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. This information is enough for us to calculate the accounts receivable ratio for XYZ in the past year.
First, we need to find the average accounts receivable:
($320,000 + $400,000) / 2 = $360,000
Then, we can 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.
Limitations of the Receivables Turnover Ratio
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.
However, there are also several limitations to this ratio that should be taken into account. 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.
- Total Sales vs. Net Sales
Not all companies use their net sales value to calculate the receivable turnover ratio. Some use their gross credit sales instead.
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.
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.
If you’re an investor trying to ascertain a company’s turnover ratio, make sure to inquire how they calculate the ratio – whether with the total sales or net sales value.
- Seasonal Companies
Seasonal businesses are characterized by specific times of the year when they are far more profitable than in others. They either close down entirely during the off-seasons, scale down their operations, or the demand for their products or services becomes much lower.
If you’re calculating the receivables turnover ratio at different times of the year, they can vary drastically. Seasonal companies can have periods of a low turnover ratio followed by periods of a high turnover ratio, depending on how easy it is to manage sales and payment collections.
Investors shouldn’t randomly choose a period for which to calculate the ratio. Depending on the business type, it should be carefully chosen to represent its effectiveness in collecting credit. Any seasonal gaps can be smoothed out by calculating the average accounts receivable for each month during a 12-month period.
- Needs Context
Once again: the accounts receivable turnover ratio alone doesn’t provide you with all the necessary information to understand why a company might be failing (or succeeding).
For example, 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 Ratios
If you are an investor looking for a good business to back or a CEO who wants to know how his company is fairing against others, you need to understand how to compare two or more accounts receivable ratios properly. People often compare vastly different organizations and draw the wrong conclusions – this is pretty much like comparing apples and oranges.
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.
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.
Conclusion
The accounts receivable turnover ratio is a decent measure of a company’s credit policies and its efficiency in collecting payments. It is calculated using a formula that includes net sales and the average accounts receivable for a specific time period. You can choose whether you want to calculate the ratio for a month, a quarter, or an entire year.
At the same time, you need to be aware that there are some limitations to this turnover ratio. Some companies use their total sales instead of net sales in the calculations, which could lead to an inflated result. Seasonal companies have vastly different ratios depending on the season. The ratio alone cannot provide you with deeper insight into why a company has a low or a high receivable turnover.
To understand how a company is managed on a bigger scale, you will need more information than only the turnover value.
Finally, when you compare ratios of different companies, make sure they belong in the same industry, are of a similar size, and maybe even with the same business model. Comparing businesses in different industries and with different capital structures doesn’t make much sense regarding the accounts receivable turnover.
Do you have any questions about driving more value out of your finance & accounting function? Contact Consero for more information and help in determining whether the accounts turnover ratio for your company is good or bad. We’d love to hear from you!
