How to Calculate (and Use) the Accounts Receivable Turnover Ratio

Use of the Receivables Turnover Ratio

The receivables turnover ratio is used to calculate how well a company is managing their receivables. The lower the amount of uncollected monies from its operations, the higher this ratio will be. In contrast, if a company has more of its revenues awaiting receipt, the lower the ratio will be.

Although the formula for the receivables turnover ratio is fairly simple, applying the ratio in a particular situation to determine efficiency can become more complex. A company needs to collect revenues in order to cover expenses and/or reinvest. A lack of collecting sooner is potentially a loss of future earnings from reinvesting. However, customers may look to competitors if the collection is overbearing.

Accounts Receivable Turnover Ratio Explained

Working toward and attaining financial security requires businesses to understand their accounts receivable turnover ratio. This efficiency ratio takes an organization’s receivable balances and receivable accounts into consideration to determine the state of its cash flow.

If a company’s receivables turnover goes unchecked and unmanaged for extended periods of time, it could mean that they are failing to regularly and accurately bill customers or remind them of money owed. This would put businesses at risk of not receiving their hard-earned cash in a timely manner for the products or services that they provided, which could obviously lead to bigger financial problems.

Making sure your company collects the money it is owed is beneficial for both internal and external financial engagements. Although accounts receivable turnover ratios are largely contextual, as they vary depending on the industry, higher ratios usually make better impressions on potential investors or financial institutions that supply loans. So practicing diligence in accounts receivable revenues directly affects an organization’s bottom line.

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What does the receivables turnover ratio tell you?

Once you have calculated your company’s accounts receivable turnover ratio, it’s nearly time to use it to improve your business. But first, you need to understand what the number you calculated tells you.

Collection time

Using your receivables turnover ratio, you can determine the average number of days it takes for your clients or customers to pay their invoices. This is also known as your average collection period.

To identify your average collection period, divide the number of days in your accounting cycle by the receivables turnover ratio.

For example, if your receivables turnover ratio for the year is 32, that means over the fiscal year, your business collected on its outstanding invoices 32 times. In this case, you divide the number of days in a year (365) by your receivables turnover ratio (32).

365 / 32 = 11.5 days

Therefore, it takes this business’s customers an average of 11.5 days to pay their bills. In most industries, that’s a high-quality customer base.

You can use this average collection period information to compare your company’s receivables turnover time with that of other companies in your industry.

Industry matters

For the most part, there are two types of ratio results—high and low. Of course, you’ll want to keep in mind that “high” and “low” are determined by industry norms. For example, giving clients 90 days to pay an invoice isn’t abnormal in construction but may be considered high in other industries.

With 90-day terms, you can expect construction companies to have lower ratio numbers. If you’re in construction, you’ll want to research your industry’s average receivables turnover ratio and compare your company’s ratio based on those averages.

Cleaning companies, on the other hand, typically require customer payment within two weeks. If you own one of these businesses, your idea of “high” or “low” ratios will be vastly different from that of the construction business owner.

High receivables turnover ratios

A high turnover ratio has many potential meanings. It most often means that your business is very efficient at collecting the money it’s owed. That’s also usually coupled with the fact that you have quality customers who pay on time. These on-time payments are significant because they improve your business’s cash flow and open up credit lines for customers to make additional purchases.

Another reason you may have a high receivables turnover is that you have strict or conservative credit policies, meaning you’re careful about who you offer credit to. When you have specific restrictions for those you offer credit to, it helps you avoid customers who aren’t credit-worthy and are more likely to put off paying their debts.

Of course, it’s still wise to make sure you’re not too conservative with your credit policies, as too restrictive policies lead to loss of clients and slow business growth.

With certain types of business, such as any that operate primarily with cash sales, high receivables turnover ratio may not necessarily point to business health. You may simply end up with a high ratio because the small percentage of your customers you extend credit to are good at paying on time.

Even if you trust the businesses that you extend credit to, there are other reasons you may want to make a more serious effort to develop a higher ratio.

For example, the accounts receivable turnover ratio is one of the metrics that business investors and lenders look at when determining whether to invest in or loan money to your business. Investors and lenders want to see receivables turnover ratios similar or slightly higher than other businesses in your industry.

Low receivables turnover ratios

A low accounts receivable turnover ratio, on the other hand, often indicates that the credit policies of the business are too loose. For example, you may allow a longer period of time for clients to pay or not enforce late fees once your deadline to pay has passed.

Credit policies that are too liberal frequently bring in too many businesses that are unstable and lack creditworthiness. This can be dangerous for the health of your own business. If you never know if or when you’re going to get paid for your work, it can create serious cash flow problems.

As a small business, cash flow issues can add up fast. When your customers don’t pay on time, it can lead to late payments on your own bills. Unpaid invoices can negatively affect the end-of-year revenue statements and scare away potential lenders and investors.

Liberal credit policies may initially be attractive because they seem like they’ll help establish goodwill and attract new customers. Although that may be true, nothing negates positive feelings like having to hassle someone over unpaid bills.

Additionally, with credit policies that are too liberal, you’re more likely to have customers who default or file for bankruptcy; when that happens, your only consolation is getting to write it off as a loss on your business’s taxes. As a rule of thumb, sticking with more conservative policies will typically shorten the time you have to wait for invoiced payments and save you from loads of cash flow and investor problems later on.

A low ratio may also indicate that your business has subpar collection processes. On the other hand, it could also be that your collection staff members are not receiving the training they need or are not assertive enough when following up on unpaid invoices.

Learn more:

What is the accounts receivable turnover ratio formula?

Now that you know what is the receivables turnover ratio definition, you’re probably wondering how to calculate the accounts receivables turnover ratio. Don’t worry, answering “what is the accounts receivable turnover ratio formula?” is not as difficult as it might sound. It consists of:

receivables turnover ratio = net credit sales / average accounts receivables,

where:

  • receivables turnover ratio shows how effective the company is at extending credit to its customers and how efficiently it gets paid back on a given day.
  • net credit sales – revenue from goods or services sold on credit on a given day – to be paid at a later date.
  • average accounts receivables – the claim to the money from previous credit sales that the business has yet to receive from customers. This variable can be further broke-down and calculated:

average accounts receivables = (accounts opening + accounts closing) / 2,

where:

  • accounts opening or accounts receivables (opening) means the amount of outstanding receivables at the start of the day
  • accounts closing or accounts receivables (closing) means the amount of outstanding receivables at the end of the day

Now that you know the secret to the accounts receivable turnover ratio formula calculator, the next section will use an example to show you how to calculate the receivables turnover ratio.

Understanding Receivables Turnover Ratios

Accounts receivable are effectively interest-free loans that are short-term in nature and are extended by companies to their customers. If a company generates a sale to a client, it could extend terms of 30 or 60 days, meaning the client has 30 to 60 days to pay for the product. The ability to collect on these debts depends on a number of factors, including financial and economic conditions and, more importantly, the client.

The receivables turnover ratio measures the efficiency with which a company is able to collect on its receivables or the credit it extends to customers. The ratio also measures how many times a company’s receivables are converted to cash in a certain period of time. The receivables turnover ratio is calculated on an annual, quarterly, or monthly basis.

A company’s receivables turnover ratio should be monitored and tracked to determine if a trend or pattern is developing over time. Companies can also track and correlate the collection of receivables to earnings to measure the impact the company’s credit practices have on profitability.

For investors, it’s important to compare the accounts receivable turnover of multiple companies within the same industry to get a sense of the normal or average turnover ratio for that sector. If one company has a much higher receivables turnover ratio than the other, it may be a safer investment. We look at what both high and low turnover ratios mean a little further below.

Accounts receivables appear under the current assets section of a company's balance sheet.

Limitations of the receivables turnover ratio

While the receivables turnover ratio can be handy, it has its limitations like any other measurement.

For example, while the ratio may be able to identify that it takes your company longer to receive payment than most in your industry, it can’t point to the specific cause or causes for the low ratio, such as problem client or underperforming collections staff. You have to do the legwork to figure all that out.

The receivables turnover ratio is also an average. And as an average, it has the potential to be skewed by even one or two outliers, such as clients who pay their invoice the day it’s issued or the one client who is always asking for more time and paid their last invoice 10 months after you sent it.

There’s no ideal ratio that applies to every business in every industry. Norms that exist for receivables turnover ratios are industry-based, and any business you want to compare should have a similar structure to your own.

Lastly, many business owners use only the first and last month of the year to determine their receivables turnover ratio. However, the time it takes to receive payments often varies from quarter to quarter, especially for seasonal companies. As a result, you should also consider the age of your accounts receivable to determine if your ratio appropriately reflects your customer payment.

How Do You Calculate the Receivables Turnover Ratio?

The receivable turns or accounts receivable turnover is a great financial ratio to learn when you are analyzing a business or a stock. It’s common sense: The faster a company collects its accounts receivables, the better. Fortunately, there is a way to calculate how often a business collects its receivables. The receivables turnover ratio formula takes the credit sales divided by the average accounts receivables to find the number of turns.

Credit sales are found on the income statement, not the balance sheet. You'll have to have both the income statement and balance sheet in front of you to calculate this equation.

Track and Improve Accounts Receivable Turnover Ratio With Accounting Software

Accurately and consistently tracking your accounts receivables and all payments owed to your organization can feel like a daunting task. But choosing a financial management system that can automate these processes helps businesses spend less time worrying about their cash flow and identifying customers that have fallen behind on their bills. For example, NetSuite’s financial management solution has dashboards that track AR turnover ratio in real time and, with a few clicks, users can see how much different clients owe and days past due for each. The system can also automatically send reminder emails — with invoices attached — to customers, taking another task off your employees’ plates. Broadly speaking, such a solution promotes greater efficiency and speed within daily monetary transactions, assures compliance with accounting standards and expedites the financial close.

Keeping up with your accounts receivable is key to maximizing cash flow and identifying opportunities for financial growth and improvement. In being proactive and persistent in ensuring that debts owed are paid in a timely fashion, businesses can boost the efficiency, reputability and profitability of their financial endeavors.

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