Accounts Receivable Turnover Ratio
Accounts receivable turnover ratio is calculated by dividing your net credit sales by your average accounts receivable. The ratio is used to measure how effective a company is at extending credits and collecting debts. Generally, the higher the accounts receivable turnover ratio, the more efficient your business is at collecting credit from your customers.
When it comes to business accounting, there are many formulas and calculations that, although seemingly complex, can nevertheless provide valuable insight into your business operations and financials. One such calculation, the accounts receivable turnover ratio, can help you determine how effective you are at extending credit and collecting debts from your customers.
Even though this may sound difficult, once you break down the accounts receivable turnover formula, you’ll find that the ratio is, in fact, rather simple to calculate. Moreover, the accounts receivable turnover ratio can be extremely useful—as understanding it can be crucial to your cash flow, to getting a loan, and to your overall business financial planning.
In this guide, therefore, we’ll break down the accounts receivable turnover ratio, discussing what it is, how to calculate it, and what it can mean for your business.
Accounts Receivable Turnover: The Basics
Before we explain how to calculate the accounts receivable turnover ratio and what it can indicate for your business, let’s start with the basics of this accounting term: What is the accounts receivable turnover ratio?
The accounts receivable turnover ratio is an accounting calculation used to measure how effectively your business (or any business) uses customer credit and collects payments on the resulting debt.
This ratio, typically measured on an annual basis, is calculated using an accounts receivable turnover formula, which requires two quantities: net credit sales and average accounts receivable.
Accounts Receivable Turnover Ratio Formula
In order to calculate your accounts receivable turnover ratio, you’ll use the following accounting receivable turnover formula:
Net credit sales / Average Accounts Receivable
Step 1: Determine your net credit sales.
The first part of the accounts receivable turnover formula calls for your net credit sales, or in other words, all of your sales for the year that were made on credit (as opposed to cash). This figure should include your total credit sales, minus any returns or allowances. You should be able to find your net credit sales number on your annual income statement or on your balance sheet.
Step 2: Determine your average accounts receivable.
Once you have your net credit sales, the second part of the accounts receivable turnover formula requires your average accounts receivable. Accounts receivable refers to the money that’s owed to you by customers. In order to find your average accounts receivable, then, you’ll take the number of your accounts receivable at the beginning of the year, add it with the value of your accounts receivable at the end of the year, and divide by two to find the average. You should be able to find the necessary accounts receivable numbers on your balance sheet.
Step 3: Divide.
Once you have these two values, you’ll be able to use the accounts receivable turnover formula. You’ll divide your net credit sales by your average accounts receivable to calculate your accounts receivable turnover ratio, or rate.
As a reminder, this ratio helps you look at the effectiveness of your credit, as your net credit sales value does not include cash since cash doesn’t create receivables. Therefore, if you have a lower number of payment collections from your customers, you’ll have a lower accounts receivable turnover ratio, and vice versa—if you have a higher number of payment collections from customers, you’ll have a higher ratio.
Accounts Receivable Turnover Ratio Example
For clarity’s sake, let’s look at an example of this accounting formula in use:
Let’s say your company had $100,000 in net credit sales for the year, with average accounts receivable of $25,000. To determine your accounts receivable turnover ratio, you would divide the net credit sales, $100,000 by the average accounts receivable, $25,000 and get four.
$100,000 (net credit sales) / $25,000 (average accounts receivable) = 4 (accounts receivable turnover ratio)
An accounts receivable turnover ratio of four indicates that your business is collecting your average receivables four times per year, or cycling through your accounts receivable once per quarter.
What Your Accounts Receivable Turnover Ratio Means
So, now that we’ve explained how to calculate the accounts receivable turnover ratio, let’s explore what this ratio can mean for your business. As we mentioned, the accounts receivable turnover ratio is used to measure the effectiveness of how you extend credit and collect debts—therefore, the higher your ratio, the more times you’re turning over your accounts receivable, which means that there’s a higher likelihood that your customers’ debts are being paid quickly.
In turn, a higher accounts receivable turnover improves your cash flow and allows you to pay your business’s debts, like payroll, as an example, more quickly. Additionally, a higher ratio means it’s more likely your business will eventually receive payments for debts instead of having to write off bad debt—a sign of a financially healthier business in general.
Moreover, in addition to calculating the likelihood and speed of the payments you’ll receive, the ratio can also indicate how well your business handles credit policy and practices as well as manages customer debt. Let’s discuss further:
High Accounts Receivable Turnover Ratio
As we mentioned, the general rule of thumb is that the higher the accounts receivable turnover rate the better. A higher ratio, therefore, can mean:
- You receive payment for debts, which increases your cash flow.
- Your collections methods are effective.
- You’re extending credit to the right kinds of customers, meaning you don’t take on as much bad debt.
- Your customers are paying off debt quickly, freeing up credit lines for future purchases.
However, it’s worth noting that a high ratio could also mean that you operate largely on a cash basis as well.
Moreover, although typically a higher accounts receivable turnover ratio is preferable, there are also scenarios in which your ratio could be too high. A too high ratio can mean that your credit policies are too aggressive, which can lead to upset customers or a missed sales opportunity from a customer with slightly lower credit. In that case, you might reconsider your credit policies to possibly increase sales as well as improve customer satisfaction.
Low Accounts Receivable Turnover Ratio
On the other hand, if you have a low accounts receivable turnover ratio, you’re probably not effectively collecting debt payments with regards to your sales. In turn, then, this could indicate a few possibilities for your business:
- Your collections policies may not be effective.
- You’re giving credit too leniently.
- Bad or uncollectible debt is hurting your cash flow.
- Your customers may be struggling to make their payments, making it less likely that they will make future purchases.
Furthermore, a low accounts receivable turnover rate could indicate additional problems in your business—ones that are not due to credit or collections processes. When companies fail to satisfy customers through shipping errors or products that malfunction and need to be replaced, your company’s turnover may slow. Therefore, if your ratio is low, you’ll want to consider a variety of factors that may be contributing and once you’ve identified the problem or problems, evaluate how you can change and better your practices to improve your accounts receivable turnover ratio.
The Importance of Your Accounts Receivable Turnover Ratio
As we’ve mentioned, your accounts receivable turnover ratio can be an important figure for your business management and planning.
By learning how quickly your average debts are paid, you can try to determine what your cash flow will look like in the coming months in order to better plan your expenses. Plus, addressing collections issues to improve cash flow can also help you reinvest in your business for additional growth.
Moreover, improving your ratio can also help you get a business loan, as many loans use accounts receivable as collateral. By improving your accounts receivable turnover ratio, you can improve the level of collateral you can offer and potentially your loan terms.
Once again, there are a variety of ways you can improve this ratio—from adjusting collections policies to collect on more payments to offering incentives to customers who pay quickly—depending, of course, upon what you determine is most greatly affecting your existing ratio.
By changing your policies to improve your ratio, though, you’ll be helping your cash flow, loan possibilities, and overall financial planning, all of which can be integral to the success of your small business.
Tracking Your Accounts Receivable Turnover
Since your accounts receivable turnover can be an accounting principle that is crucial to your business, you’ll want to be sure that part of your business accounting processes includes tracking it and determining where you have opportunities to improve policies, and therefore, your bottom line. By tracking your accounts receivable turnover rate over time, you can get a clear view of how your business extends and collects credit and see whether the trends are moving in the right direction year after year.
Moreover, with regard to your future business financing, some lenders might look at your accounts receivable turnover to help them decide if they should work with your business. When comparing two very similar businesses, the one with a higher receivables turnover ratio may be a smarter investment for a lender—making it even more important for you to track yours and improve it, if necessary.
Limitations of the Accounts Receivables Turnover Ratio
Though we’ve discussed how this metric can be helpful in assessing how long it takes your business to collect on credit, you’ll also want to remember that just like any metric, it has its limitations.
First, although accounts receivables turnover ratio can help you spot trends, it can’t really help you identify bad customer accounts that may need extra review, such as those that are far past due.
Additionally, since the ratio is based on an average it can be skewed by customers who pay exceptionally quickly and similarly by accounts that pay extremely slowly, making it a less accurate measure of your credit effectiveness. Furthermore, accounts receivables can vary throughout the year, which means your ratio can be skewed simply based on the start and endpoint of your average. Therefore, you should also look at account aging to ensure your ratio is an accurate picture of your customers’ payment.
Lastly, when it comes to comparing different companies accounts receivables turnover rates, only those companies who are in the same industry and have similar business models should be compared. Comparing the accounts receivables turnover of companies of varying sizes or capital structures is not particularly useful and you should use caution in doing so.
The Bottom Line
At the end of the day, even if calculating and understanding your accounts receivable turnover ratio may seem difficult at first, in reality, it’s a rather simple (and certainly important) accounting measurement. Once you’ve used the accounts receivable turnover formula to find your ratio, you can identify issues in your business’s credit practices and help improve cash flow.
Although this metric is not perfect, it’s a useful way to assess the strength of your credit policy and your efficiency when it comes to accounts receivables. Plus, if you discover that your ratio is particularly high or low, you can work on adjusting your policies and processes to improve the overall health and growth of your business.
This being said, in order to best monitor your business finances, accounting, and bookkeeping, we’d recommend investing in robust accounting software, like QuickBooks, for example. With an intuitive accounting platform, you’ll be able to more easily track your expenses, invoices, and customer payments—making calculating and tracking your accounts receivable turnover even simpler as well.
Moreover, if you believe your business would benefit from experienced, hands-on assistance in accounting and finance, it’s always good to consult a business accountant or financial advisor. These professionals can help you manage your planning, policies, and answer any questions you have, about accounts receivable turnover, or otherwise.