A guide to the accounts receivable turnover ratio
Effective accounts receivable management is crucial when it comes to maintaining healthy cash flow, building operational resilience, and fueling growth. By managing accounts receivable more effectively, you can enhance its performance. This offers a range of benefits, including the ability to put the money you’re owed to use more quickly.
Before you think about improving accounts receivable performance, you need a clear understanding of its current state. That makes it necessary to adopt key performance indicators (KPIs) or metrics designed specifically to measure accounts receivable performance. Accounts receivable turnover ratio is a particularly suitable metric in this respect.
What is accounts receivable turnover ratio?
The accounts receivable turnover ratio (also known as the receivables turnover ratio) is an accounting metric that quantifies how efficiently a company collects its receivables from customers or clients. Measuring the number of times that accounts receivables are turned into cash during a given period, the ratio is essentially a lens through which a company can gauge the effectiveness of its accounts receivable process. The higher the turnover ratio, the more efficient the process.
Accounts receivable turnover ratio is similar to another commonly used metric: days sales outstanding. Whereas DSO is calculated by dividing a business’s accounts receivable by its sales, the receivables turnover ratio is calculated by dividing a business’s total credit sales by its average accounts receivable. Another difference between the two metrics is that DSO is expressed in days rather than as a ratio.
Accounts receivable turnover ratio formula
The accounts receivable turnover ratio expresses the time taken to collect outstanding debt throughout the accounting period. The formula for working it out is as follows:
Accounts receivable turnover = Net credit sales / Average accounts receivable
- Net credit sales are the amount of revenue generated by goods and services by a business sold to customers on credit terms, excluding cash sales.
- Average accounts receivable is the amount of money tied up in accounts receivable (monies due to be paid).
How to calculate accounts receivable turnover ratio
You can calculate the accounts receivable turnover ratio by following these steps:
- The accounts receivable turnover ratio relates to a particular timeframe, with inputs taken from a specific period. As such, the first step is to choose the timeframe you want to measure.
- The next step is to work out the net credit sales figure, which involves removing discounts, sales returns, and allowances from the gross credit sales figure.
Net credit sales = Gross credit sales – Sales discounts – Sales returns – Sales allowances
- You can then calculate the average accounts receivable by adding the opening accounts receivable balance and closing balance for the period and dividing the figure by two.
Average accounts receivable = (Opening balance + Closing balance) / 2
- Finally, divide the total credit sales by the average accounts receivable to calculate the accounts receivable turnover ratio.
Accounts receivable turnover ratio example
During the period from January 1 to December 31, Company X had gross credit sales of $2.3 million. With sales discounts of $100,000, sales returns of $125,000, and sales allowances of $75,000, its net credit sales were $2 million.
$2,300,000 – $100,000 – $125,000 – $75,000 = $2,000,000
The company had an opening accounts receivable balance of $420,000 and a closing balance of $380,000, giving an average accounts receivable of $400,000.
$420,000 + $380,000 / 2 = $400,000
So, with net credit sales of $2,000,000 and average accounts receivable of $400,000, Company X’s receivables turnover ratio was 5.0.
$2,000,000 / $400,000 = 5.0
In other words, Company X collected its average accounts receivables five times during the one-year period.
Understanding your accounts receivable turnover ratio
A high accounts receivable turnover indicates that customers pay their invoices relatively quickly. This could be due to having a reliable customer base or the business’s efficient accounts receivable process.
However, it’s important to note that the receivables turnover ratio may be artificially high if the business is overly reliant on cash sales or if it has a restrictive credit policy. This could lead to depressed sales as customers seek firms willing to offer more generous credit terms.
By contrast, a low receivables turnover ratio may indicate an inefficient collection process, bad credit policies, or an unreliable customer base. It can also be influenced by factors such as slow deliveries or poor quality, leading to delayed or disputed invoice payments.
Using the accounts receivable turnover ratio
Like any metric, the receivables turnover ratio has its limitations. For example, businesses with seasonal or cyclical sales models will see large fluctuations at different times, making the ratio less accurate in measuring overall credit effectiveness.
Whereas DSO measures the average number of days taken to collect on receivables, the receivables turnover ratio measures how many times a business’s receivables are turned over in a given period. It can be a good way to determine whether a company’s collections policy is trending faster or slower over time. Because of this, the receivables turnover ratio is best used as a comparative metric.
It can also be used to compare the efficiency of a business’s AR process to others of a similar size operating in the same industry, providing that they use the same metrics and inputs.
How to improve the accounts receivable turnover ratio
Companies may be able to drive improvements to the receivables turnover ratio by taking the following steps:
- Streamline and automate processes: Ensuring that invoices are simple, correctly itemized, and sent quickly increases the likelihood of prompt payment. As such, process automation can result in clear benefits, from making it easier for businesses to create, send and track invoices to enabling customers to view and pay online.
- Use AR financing: AR financing is an arrangement that operates as a line of credit backed by outstanding debts. It allows a company to unlock working capital tied up in its accounts receivable and deploy otherwise unusable capital until the invoice is settled.
- Communicate effectively: With clear channels of communication and strong relationships, difficulties in the AR process can often be resolved more easily or avoided altogether. This may include working with customers to prevent problems from recurring.
- Offer early payment discounts: Offering early payment discounts on your invoices incentivizes customers to pay faster. Customers can benefit from a lower cost of goods while you speed up your collections process – thereby improving your accounts receivable turnover ratio.