The accounts receivable turnover ratio is one metric to watch closely as it measures how effectively a company is handling collections. If money is not coming in from customers as agreed and expected, cash flow can dry to a trickle.
Conversely, when collections are managed efficiently, the business’ cash flow becomes more predictable, collection costs are lower and its balance sheet is healthier, which is a very important factor when a company seeks to obtain credit, invest in growth and attract investors.
What is Accounts Receivable (AR) Turnover Ratio?
The accounts receivable turnover ratio is used in business accounting to quantify how well companies are managing the credit that they extend to their customers by evaluating how long it takes to collect the outstanding debt throughout the accounting period.
For example, Joe’s Bait Company supplies fish bait to stores at docks and marinas throughout the Southeast. The company invoices each of the stores once a month. Payment terms are the same for each customer: net30, meaning payment is due thirty days after the invoice date. Some of the company’s customers pay on time as agreed, but some pay late. A few may go out of business and not pay Joe’s Bait Company anything at all.
By comparison, LookeeLou Cable TV company delivers cable TV, internet and VoIP phone service to consumers. All customers are billed a month in advance of service delivery, thereby preventing any customer from receiving services without paying the bill. In other words, its accounts receivables are better protected as service can be disconnected before further credit is extended to the customer.
In both cases, the accounts receivable turnover ratio shows how long it takes customers to pay, on average, and that information in turn reveals a lot about how financially stable the company is and how well its cash flow is managed.
5 Key Takeaways:
- A high AR turnover ratio is usually desirable, but not if credit policies are too restrictive and negatively impact sales.
- While a low AR turnover ratio won’t score points with lenders, it doesn’t always indicate risky customers. In some cases, the business owner may offer terms that are too generous or may be at the mercy of companies that require a longer than 30 day payment cycle.
- Turnover ratio needs to be taken in context with the business type—companies with high a AR turnover are a result of the processes in place to secure payment—for example retail, grocery stores, etc. So it is good practice to compare yourself with others in your industry.
- As noted above business type and industry can impact your AR ratio so the score viewed on its own may not reflect the quality of your customer base or effectiveness of your retention efforts—it needs to be viewed in context.
- You can improve your ratio by being more effective in your billing efforts and improving your cash flow.
How to Calculate Accounts Receivable (AR) Turnover Ratio
Also known as the “receivable turnover” or “debtors turnover” ratio, the accounts receivable turnover ratio is an efficiency ratio—specifically an activity financial ratio—used in financial statement analysis. It measures how efficiently and quickly a company converts its account receivables into cash within a given accounting period.
Accounts Receivable (AR) Turnover Ratio Formula & Calculation: The AR Turnover Ratio is calculated by dividing net sales by average account receivables. Net sales is calculated as sales on credit - sales returns - sales allowances. Average accounts receivables is calculated as the sum of starting and ending receivables over a set period of time (generally monthly, quarterly or annually), divided by two.
The formula for calculating the AR turnover rate for a one-year period looks like this:
Net Annual Credit Sales ÷ Average Accounts Receivables = Accounts Receivables Turnover
For example, Flo’s Flower Shop sells floral arrangements for corporate events and accepts credit. The shop totaled $100,000 in gross sales. Starting accounts receivables for the year were $10,000. Ending accounts receivables for the year were $15,000. The formula for calculating how many times in that year Flo collected her average accounts receivables looks like this:
Accounts Receivable Turnover Ratio = $100,000 - $10,000 / ($10,000 + $15,000)/2 = 7.2
In financial modeling, the accounts receivable turnover ratio is used to make balance sheet forecasts. The AR balance is based on the average number of days in which revenue will be received. Revenue in each period is multiplied by the turnover days and divided by the number of days in the period to arrive at the AR balance.
To calculate the ratio in days, in order to know the average number of days it takes a client to pay on a credit sale, the formula looks like this:
Accounts Receivable Turnover in Days = 365 / Accounts Receivables Turnover Ratio
Or, in the Flo’s Flower Shop example above, the calculation would look like this:
Accounts Receivable Turnover in Days = 365 / 7.2 = 50.69
What is a good accounts receivable turnover ratio?
Generally speaking, a higher number is better. It means that your customers are paying on time and your company is good at collecting debts.
A bigger number can also point to better cash flow and a stronger balance sheet or income statement, balanced asset turnover and even stronger credit worthiness for your company.
But there are circumstances where this general rule may not hold true.
Do you want a higher or lower accounts receivable turnover?
A high accounts receivables turnover ratio can indicate that the company is conservative about extending credit to customers and is efficient or aggressive with its collection practices. It can also mean the company’s customers are of high quality, and/or it runs on a cash basis.
Not all of those things are necessarily good, however. If a company is too conservative in extending credit, it may lose sales to competitors or incur a sharp drop in sales when the economy slows. Businesses must evaluate whether a lower ratio is acceptable to offset tough times.
Conversely, a low ratio may indicate that a company is poorly managed, extends credit too easily, spends too much on operations, serves a financially riskier customer base and/or is negatively impacted by a broader economic event.
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Accounts Receivable (AR) Turnover Ratio Examples
Every company sells a product and/or service, invoices for the same, and collects payment according to the terms set forth in the sale.
But there are variances in how well companies manage collections from that point forward. Here are some examples of specific scenarios.
High Accounts Receivable Turnover Ratio
Dr. Blanchard is a dentist who accepts insurance payments from a limited number of insurers, and cash payments from patients not covered by those insurers. His accounts receivable turnover ratio is 10, which means that the average accounts receivable are collected in 36.5 days. That bodes well for his cash flow and his personal goals.
But it may also make him struggle if his credit policies are too tight during an economic downturn, or if a competitor accepts more insurance providers or offers deep discounts for cash payments.
Low Accounts Receivable Turnover Ratio
Ron Harris runs a local yard service for homeowners and few small apartment complexes. He is always short-handed and overworked, so he invoices customers whenever he can grab a free hour or two. Even though Ron’s customers generally pay on time, his accounts receivable ratio is 3.33 because of sporadic invoicing and irregular invoice due dates. Ron’s account receivables are turning into bankable cash about three times a year, meaning it takes about four months for him to collect on any invoice.
Tracking Receivables Turnover Ratio
Tracking your accounts receivable ratios over time is crucial to your business. If it dips too low, that is an indication that you need to tighten your credit policies and increase collection efforts. If it swings too high, you may be too aggressive on credit policies and collections and be curbing your sales unnecessarily.
By knowing how quickly your invoices are generally paid, you can plan more strategically because you will have a better handle on what your future cash flow will be.
Maintaining a good ratio track record also makes you and your company more attractive to lenders, so you can raise more capital to expand your business or save for a rainy day.
Receivables vs. Asset Turnover Ratio
An asset turnover ratio measures the efficiency of a company’s use of its assets to generate revenue. The accounts receivables ratio, on the other hand, measures a company’s efficiency in collecting money owed to it by customers.
Importance of Your Accounts Receivable Turnover Ratio
The accounts receivable ratio serves two critical business purposes. First, it enables companies to understand how quickly payments are collected so they can pay their own bills and strategically plan future investments.
Secondly, the ratio enables companies to determine if their credit policies and processes support good cash flow and continued business growth—or not.
Tracking Your Accounts Receivable Turnover
Tracking your accounts receivables turnover will help you identify opportunities for improvements in your policies to shore up your bottom line. Tracking the turnover over time can help you improve your collection processes and forecast your future cash flow. Also, it can help you get a bank loan. Your banker will want to see this track to determine the bank’s risk since accounts receivables are often used as collateral. A higher accounts receivables turnover ratio will be considered a better lending risk by the banker.
Limitations of the Accounts Receivables Turnover Ratio
Like most business measures, there is a limit to the usefulness of the accounts receivables turnover ratio. For one thing, it is important to use the ratio in context of the industry. For example, grocery stores usually have high ratios because they are cash-heavy businesses, so AR turnover ratio is not a good indication of how well the store is managed overall.
Meanwhile manufacturers typically have low ratios because of the necessary long payment terms, so the ratio for this group must be taken in context to derive a more useful meaning.
Your ratio highlights overall customer payment trends, but it can’t tell you which customers are headed for bankruptcy or leaving you for a competitor. Nor can it tell you who your best customers are.
Further, if your business is cyclical, your ratio may be skewed simply by the start and endpoint of your accounts receivable average. Compare it to Accounts Receivable Aging—a report that categorises AR by the length of time an invoice has been outstanding—to see if you are getting an accurate AR turnover ratio.
5 Tips to Improve Your Accounts Receivable (AR) Turnover Ratio
If your AR turnover ratio is low, you probably need to make some changes in credit and collection policies and procedures. Here are five things you can do to improve your ratio.
- Invoice regularly and accurately. It doesn’t matter how busy everyone in your company is—if invoices do not go out on time, then money will not come in on time either. Accounting software can help you automate many aspects of the invoicing process and can guard against errors such as double billing.
- Always state payment terms. You cannot enforce policies that you have not announced to clients. Make sure contracts, agreements, invoices and appropriate client communications cover this important point so customers are not surprised and you can collect your payments on a timely basis.
- Offer multiple ways to pay. Just like some customers like to call while others prefer to communicate online, the same is true for a customer’s payment preference. By making several different payment methods available, customers can more easily pay. And what is easy to do usually gets done!
- Set follow-up reminders. Do not wait until customers are weeks or months in arrears to start collection procedures. Be proactive, but not annoying, with reminders for customers. Set internal triggers to activate collection escalations sooner rather than later or consider implementing a dunning process, escalating attempts to collect from customers.
- Consider offering discounts for cash and prepayments. You can reduce the costs in account receivables and improve your ratio by encouraging customers to pay ahead or in cash, rather than on your normal customer credit terms.
