Accounts Receivable Turnover Ratio: Formula & Examples
Accounting is a key component of any business irrespective of its size. There are several formulas and calculations involved in accounting that can make it complex to undertake for unskilled workers, however, they provide valuable insights into a company’s financial health and business operations.
One key metric that is valuable for businesses is the accounts receivable turnover ratio. This ratio measures how effective your business is at offering credit and collecting debts from your customers.
Businesses that handle their collections well (have a good account receivable turnover ratio) will enjoy more success at obtaining loans and attracting investors.
In this guide, you will learn everything you need to know about accounts receivable turnover ratio including how to calculate it, what it can tell you, how to improve it, what makes a good account receivable turnover ratio.
Let’s get started.
What is the Accounts Receivable Turnover Ratio?
The accounts receivable turnover ratio calculates how effectively a company collects accounts receivable (the money a customer owes the company). Another name for accounts receivable turnover ratio is debtors turnover ratio.
When a company’s accounts receivable procedure is effective, and a large number of clients pay the money they owe the company quickly, this means the company may have a very high accounts receivable turnover ratio.
A company’s accounts receivable turnover ratio can be high, which means the company might be prudent when giving credit. It is not a bad thing, but it may drive potential clients away and they might move to other competing companies that can offer the credit they want.
Low accounts receivable turnover ratios might be caused by the company’s bad credit strategies and a very imperfect way of collecting accounts receivable. Or they deal with customers that pay at a later date than the date required to pay.
A good accounts receivable turnover ratio is a very necessary part of small business bookkeeping. It is also important for generating a perfect statement of income and balance sheet estimation.
When offering accounts receivable, you have to make sure it matches your company’s credit strategy. This will help you sustain a good cash flow and keep a perfect relationship with your customers. You can be more efficient when billing your client and boosting your cash flow, this will improve your account receivable ratio.
How to Calculate Accounts Receivable Turnover Ratio (+ Formula)
Accounts receivable turnover ratio measures the number of times in a given period (monthly, quarterly, or yearly) that a company always collects the average accounts receivable.
The formula to compute the receivables turnover ratio is net credit sales divided by average accounts receivable:
Net Credit Sales ÷ Average Accounts Receivable = Accounts Receivable Turnover Ratio
- Calculate Your Net Credit Sales: These are the sales you made all through the year that was on credit. You can use your balance sheet to find your net credit sales. Net sales are determined as (Sales on Credit) – (Sales Returns) – (Sales Allowances).
- Get Your Average Accounts Receivable: This is determined by adding the total amount of account receivables at the start of a year with accounts receivable at the end of a year. The total is then divided by two.
- Determine Accounts Receivable Turnover: Divide the net credit sales by average account receivable, you will get the receivables turnover ratio.
In financial accounting, the accounts receivable turnover ratio can be used to create balance sheet forecasts which are necessary for the business.
The accounts receivable balance depends on the average amount of days that return will be received. Revenues received in each period will be multiplied by the number of turnover days and divided by the days in the period it arrived at the accounts receivable balance.
Accounts Receivable Turnover Ratio Example
Here is an example to explain how to use the accounts receivable turnover ratio.
A company sells animal food. They give out credit sales for their customers and for a whole financial year ending 31st of December 2020, they recorded $4,000,000 for the annual credit sales, with returns of $100,000.
The company’s accounts receivable started with $400,000 in 2020 and the accounts receivable at the end were $600,000.
Putting these values in the formula, we are going to get:
Net Credit Sales ÷ Average Accounts Receivable = Accounts Receivable Turnover ratio
($4,000,000 – $100,000) ÷ (($400,000 + $600,000) ÷ 2) = 7.8
The company were able to collect its average accounts receivable 7.8 times during a financial year ending 31st of December 2020
You can also calculate the average period of accounts receivable in days which means the total days it takes the company to collect them during a fiscal From the above example, dividing 365 by 7.8 will give us the average period. The average accounts receivable in days will be 365 days by 7.8, which will give you 46.79.
A company can increase its turnover ratio by giving discounts to customers that will pay early. It knows the expected date to get its payment because it depends on how much they have available to settle its short-term liabilities.
What the Receivables Turnover Ratio Can Tell You
The receivables turnover ratio can tell you a lot about your business operations and financials. It does not require a keen vision to comprehend everything. Your accountant has the necessary skills to handle all of the accounts. However, there are several things you may learn from the receivables turnover ratio.
1. Receivables Are Regarded as Free Loans
The amount owed to your company by a customer is known as the receivable amount. This sum is supposed to be paid at the time of purchase. A business, on the other hand, gives the consumer 30 – 60 days to make the payment while billing.
The total time it takes a buyer to make a payment is considered interest-free time. This credit amount is comparable to that of a loan. However, the company does not impose interest on the money. As a result, it qualifies as an interest-free loan.
2. Efficiency When Collecting Accounts Receivable
The receivables turnover ratio assists in determining the efficiency with which the company collects its receivables. It also ensures to calculate how many times they were able to collect receivables. This report shows how much cash the company has made over a month, quarter, and year.
A company's receivables turnover ratio should be evaluated and monitored over time to see if a pattern or trend emerges. Companies can also keep track of receivables collection and compare it to earnings to get the influence of credit procedures on profitability.
What is a Good Accounts Receivable Turnover Ratio?
In general, the bigger the number, the better. A good accounts receivable turnover ratio indicates that your consumers pay on time and that your organization is efficient at debt collection.
High accounts receivable turnover ratios can indicate a good cash flow, a regulated asset turnover, and a good credit rating for your company. However, sometimes this rule does not apply.
Do you want your accounts receivable turnover to be higher or lower? High accounts receivable can indicate that a company is reluctant to give out credit to customers and that its collection tactics are effective. It could also indicate that the company's customers are of high quality and that it operates on a basis of cash.
Not all of those factors are positive. When the economy is slow, a company that is cautious in offering credit may risk losing sales to competitors or suffer a decline in sales. The company must assess if a low ratio is allowed to balance tough times.
A low ratio can indicate a company is not managed well and also provides credit too easy, and spend a lot on business operations that can adversely affect the company
How to Improve Your Accounts Receivable Turnover Ratio
The accounts receivable turnover ratio measures how effective a company is at collecting money owed by its customers or clients. If the ratio is high, the business is expanding and making a profit. However, if the ratio is very low, the business is losing money.
If you are a business owner, you will always want to run your firm while making money.
1. Make Billing Efficient
When done manually, billing can be time-consuming. According to statistics, 20 percent of the time being spent on billing is wasted. To avoid the use of manual labor and to work efficiently, manual billing should be canceled.
The introduction of automated billing and invoicing software will save time, almost eliminate errors, and will assist the company to create strong documentation of sales. Data entry will be improved, and the company will be able to save a lot of time and effort manually charging each sold item.
To do this, make sure you choose the payment option in advance, as well as the terms of the transaction. Also, the team should be motivated when it comes to billing. An invoice should be attached when doing billing.
2. Everything Should Be Invoiced Properly
Your Invoice determines when revenue should come in. Several businesses make the error of failing to issue an invoice immediately following a sale. Occasionally, businesses will create a confusing and lengthy invoice that the customer will find difficult to understand.
When the company makes invoices after sales at delayed times, the company facilitates delayed payments, resulting in a decrease in the accounts receivable turnover ratio.
Every sale should be invoiced quickly, thoroughly, and precisely. The sales team must be encouraged to practice instant invoicing to eliminate the errors. Once the invoicing is completed quickly, the organization should begin refusing to accept late payments.
3. Improve Customer Relationship
Concentrate on improving customer relationships. Make sure the customer has a good encounter with the company. Work on strengthening customer relationships. A company that has strong connections with its customers is more likely to gain their trust thereby increasing its Customer Lifetime Value (CLV).
When a company and a customer have a cordial relationship, the customer is more likely to fulfill their payment obligations. Customers frequently avoid delays on purpose since they are satisfied with the business.
4. Flexible Payment Options and Discounts
Offering a fair choice of payment methods not only allows you to reach out to more customers but also streamlines payment, boosting the chances of getting paid on time and in full.
Everyone likes a good deal, so do not be scared to give your customers discounts if they pay in advance or buy in cash. This helps reduce your accounts receivable costs while increasing your accounts receivable turnover rate.
5. Reward Advance Payments
Humans tend to view benefits as expressions of appreciation. A company can start rewarding customers for making upfront payments to promote immediate payment. The customer-business ties will be strengthened as a result of this. It will also assist the company in determining the customer's payment capability for future engagements.
Limitations of Using the Receivables Turnover Ratio
An investor or a company owner needs to be aware of the receivables turnover ratio's limitations. When deciding whether or not to invest in a firm, it is critical to understand the limitations of the receivables turnover ratio to make a favorable decision.
1. False Sales Estimate
Some businesses give out inaccurate sales predictions, whether on purpose or by mistake. Several businesses sometimes calculate the value of the receivables turnover ratio on total sales rather than net sales. This inflates the data wrongly. As a result, organizations end up providing a false assessment of their ratio and profitability.
2. Accounts Receivable Can Vary
Receivables fluctuate during the year, which is another limitation to the receivables turnover ratio. Seasonal businesses, for example, will have times with higher receivables and possibly a low turnover ratio, as well as periods when receivables are low and easier to manage and collect.
3. Inconsistent Time Frame for Calculation
Also, if an investor picks a beginning and ending point for calculating the ratio of receivable turnover at random, the ratio might not properly reflect the company's capability to collect and give credit.
As a result, while calculating the average accounts receivable, the beginning and ending figures should be carefully determined to appropriately reflect the performance of the company.
Investors may use an aggregate of accounts receivable from each month over twelve months to balance out periodic fluctuations.