The accounts receivable turnover ratio is one metric to watch closely as it measures howeffectively a company is handling collections. If money is not coming in from customers asagreed and expected, cash flow can dry to a trickle.
Conversely, when collections are managed efficiently, a business’s cash flow becomesmore predictable, collection costs are lower and its balance sheet is healthier, which is avery important factor when a company seeks to obtain credit, invest in growth and attractinvestors.
What Is Accounts Receivable (AR) Turnover Ratio?
The accounts receivable turnover ratio, or receivables turnover, is used in businessaccounting to quantify how well companies are managing the credit that they extend to theircustomers by evaluating how long it takes to collect the outstanding debt throughout theaccounting period.
For example, Joe’s Bait Company supplies fish bait to stores at docks and marinasthroughout the Southeast. The company invoices each of the stores once a month. Paymentterms are the same for each customer: net30, meaning payment is due thirty days after theinvoice date. Some of the company’s customers pay on time as agreed, but some paylate. A few may go out of business and not pay Joe’s Bait Company anything at all,which would result in bad debt.
By comparison, LookeeLou Cable TV company delivers cable TV, internet and VoIP phone serviceto consumers. All customers are billed a month in advance of service delivery, therebypreventing any customer from receiving services without paying the bill. In other words, itsaccounts receivablesare better protected as service can be disconnected before further credit is extended to thecustomer.
In both cases, the accounts receivable turnover ratio shows how long it takes customers topay, on average, and that information, in turn, reveals a lot about how financially stablethe company is and how well its cash flow is managed.
Receivables vs. Asset Turnover Ratio
An asset turnover ratio measures the efficiency of a company’s use of its assets togenerate revenue. The accounts receivables ratio, on the other hand, measures acompany’s efficiency in collecting money owed to it by customers.
Key Takeaways
- A high AR turnover ratio is usually desirable, but not if credit policies are toorestrictive and negatively impact sales.
- While a low AR turnover ratio won’t score points with lenders, it doesn’talways indicate risky customers. In some cases, the business owner may offer terms thatare too generous or may be at the mercy of companies that require a longer than 30 daypayment cycle.
- Turnover ratio needs to be taken in context with the business type — companieswith highAR turnover are a result of the processes in place to secure payment — forexample,retail, grocery stores, etc. So it is good practice to compare yourself with others inyour industry.
- As noted above, business type and industry can impact your AR ratio, so the score viewedon its own may not reflect the quality of your customer base or effectiveness of yourretention 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.
Accounts Receivable Turnover Ratio Explained
Working toward and attaining financial security requires businesses to understand theiraccounts receivable turnover ratio. This efficiency ratio takes an organization's receivablebalances 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 periodsof time, it could mean that they are failing to regularly and accurately bill customers orremind them of money owed. This would put businesses at risk of not receiving theirhard-earned cash in a timely manner for the products or services that they provided, whichcould obviously lead to bigger financial problems.
Making sure your company collects the money it is owed is beneficial for both internal andexternal financial engagements. Although accounts receivable turnover ratios are largelycontextual, as they vary depending on the industry, higher ratios usually make betterimpressions on potential investors or financial institutions that supply loans. Sopracticing diligence in accounts receivable revenues directly affects anorganization’s bottom line.
Importance of Accounts Receivable Turnover Ratio
The accounts receivable ratio serves two critical business purposes. First, it enablescompanies to understand how quickly payments are collected so they can pay their own billsand strategically plan future investments.
Secondly, the ratio enables companies to determine if their credit policies and processessupport good cash flow and continued business growth — or not.
What Can Accounts Receivable Ratio Tell You?
Accounts receivable ratios are indicators of a company’s ability to efficiently collectaccounts receivable and the rate at which their customers pay off their debts. Althoughnumbers vary across industries, higher ratios are often preferable as they suggest fasterturnover and healthier cash flow. Businesses that get paid faster tend to be in a betterfinancial position.
Accounts Receivable (AR) Turnover Ratio Formula & Calculation
Also known as the “receivable turnover” or “debtors turnover” ratio,the accounts receivableturnover ratio is an efficiency ratio — specifically an activity financial ratio— used infinancial statement analysis. It measures how efficiently and quickly a company converts itsaccount receivables into cash within a given accounting period.
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. Averageaccounts receivable is calculated as the sum of starting and ending receivables over a setperiod 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 ReceivablesTurnover
For example, Flo’s Flower Shop sells floral arrangements forcorporate events and accepts credit. The shop totaled $100,000 in gross sales. Startingaccounts receivables for the year were $10,000. Ending accounts receivables for the yearwere $15,000. The formula for calculating how many times in that year Flo collected heraverage accounts receivables looks like this:
Accounts Receivable TurnoverRatio = $100,000 - $10,000 / ($10,000 + $15,000)/2 = 7.2
In financial modeling, the accounts receivable turnover ratio is usedto make balance sheet forecasts. The AR balance is based on the average number of days inwhich revenue will be received. Revenue in each period is multiplied by the turnover daysand 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 aclient to pay on a credit sale, the formula looks like this:
Accounts Receivable Turnoverin Days = 365 /Accounts Receivables Turnover Ratio
Or, in the Flo’s Flower Shop example above, the calculation wouldlook like this:
Accounts Receivable Turnoverin 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 ontime and your company is good at collecting.
A bigger number can also point to better cash flow and a stronger balance sheet or incomestatement, balanced asset turnover and even stronger creditworthiness for your company.
But there are circ*mstances where this general rule may not hold true.
Do You Want a Higher or Lower Accounts Receivable Turnover?
A high accounts receivable turnover ratio can indicate that the company is conservative aboutextending 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 cashbasis.
Not all of those things are necessarily good, however. If a company is too conservative inextending credit, it may lose sales to competitors or incur a sharp drop in sales when theeconomy slows. Businesses must evaluate whether a lower ratio is acceptable to offset toughtimes.
Conversely, a low ratio may indicate that a company is poorly managed, extends credit tooeasily, spends too much on operations, serves a financially riskier customer base and/or isnegatively impacted by a broader economic event.
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Accounts Receivable Turnover Ratio Examples
Every company sells a product and/or service, invoices for the same, and collects paymentaccording 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 receivableturnover ratio is 10, which means that the average accounts receivable are collected in 36.5days. That bodes well for his cash flow and his personal goals.
But this may also make him struggle if his credit policies are too tight during an economicdownturn, or if a competitor accepts more insurance providers or offers deep discounts forcash payments.
Low Accounts Receivable Turnover Ratio
Ron Harris runs a local yard service for homeowners and few small apartment complexes. He isalways short-handed and overworked, so he invoices customers whenever he can grab a freehour or two. Even though Ron’s customers generally pay on time, his accountsreceivable ratio is 3.33 because of his 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 Accounts Receivable Ratios
Tracking your accounts receivable ratios over time is crucial to your business. If it dipstoo low, it’s an indication that you need to tighten your credit policies and increasecollection efforts. If it swings too high, you may be too aggressive on credit policies andcollections and curbing your sales unnecessarily.
By knowing how quickly your invoices are generally paid, you can plan more strategicallybecause 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 tolenders, so you can raise more capital to expand your business or save for a rainy day.
Tracking Your Accounts Receivable Turnover
Tracking your accounts receivable turnover will help you identify opportunities forimprovements in your policies to shore up your bottom line. Tracking the turnover over timecan help you improve your collectionprocesses 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 accountsreceivables are often used as collateral. A higher accounts receivable turnover ratio willbe considered a better lending risk by the banker.
Limitations of the Accounts Receivable Turnover Ratio
Like most business measures, there is a limit to the usefulness of the accounts receivableturnover ratio. For one thing, it is important to use the ratio in the context of theindustry. For example, grocery stores usually have high ratios because they are cash-heavybusinesses, so AR turnover ratio is not a good indication of how well the store is managedoverall.
Meanwhile, manufacturers typically have low ratios because of the necessary long paymentterms, 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 whichcustomers are headed for bankruptcy or leaving you for a competitor. Nor can it tell you whoyour best customers are.
Further, if your business is cyclical, your ratio may be skewed simply by the start andendpoint of your accounts receivable average. Compare it to Accounts Receivable Aging— areport that categorizes AR by the length of time an invoice has been outstanding — tosee ifyou 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 andcollection 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 donot goout on time, then money will not come in on time either. Accounting software canhelp you automate many aspects of the invoicing process and can guard against errorssuch as double billing.
Always state payment terms.
You cannot enforce policies that you have not announced to clients. Make surecontracts, agreements, invoices and appropriate client communications cover thisimportant point so customers are not surprised and you can collect your payments ona timely basis.
Offer multiple ways to pay.
Just like some customers like to call while others prefer to communicate online, thesame is true for a customer’s payment preference. By making several differentpayment methods available, customers can more easily pay. And what is easy to dousually gets done!
Set follow-up reminders.
Do not wait until customers are weeks or months in arrears to start collectionprocedures. Be proactive, but not annoying, with reminders for customers. Setinternal triggers to activate collection escalations sooner rather than later orconsider implementing a dunning process(opens in a new tab), escalating attempts to collect fromcustomers.
Consider offering discounts for cash and prepayments.
You can reduce the costs in account receivables and improve your ratio by encouragingcash sales, in which customers pay ahead or in cash, rather than on credit.
Track and Improve Accounts Receivable Turnover Ratio With Accounting Software
Accurately and consistently tracking your accounts receivables and all payments owed to yourorganization can feel like a daunting task. But choosing a financial management system thatcan automate these processes helps businesses spend less time worrying about their cash flowand identifying customers that have fallen behind on their bills. For example, NetSuite’s financial managementsolution has dashboards that track AR turnover ratio in real time and, with a fewclicks, users can see how much different clients owe and days past due for each. The systemcan also automatically send reminder emails — with invoices attached — tocustomers, takinganother task off your employees’ plates. Broadly speaking, such a solution promotesgreater efficiency and speed within daily monetary transactions, assures compliance withaccounting standards and expedites the financial close.
Keeping up with your accounts receivable is key to maximizing cash flow and identifyingopportunities for financial growth and improvement. In being proactive and persistent inensuring that debts owed are paid in a timely fashion, businesses can boost the efficiency,reputability and profitability of their financial endeavors.
Accounts Receivable Turnover Ratio FAQs
How is accounts receivable turnover calculated?
The accounts receivable turnover ratio is calculated by dividing net sales by the average accounts receivables for a certain period. The formula looks like this:
Accounts Receivable Turnover Ratio = Net Annual Credit Sales / Average Accounts Receivables
Net annual credit sales are calculated as sales on credit minus sales returns and sales allowances. Average accounts receivable is calculated as the sum of the starting and ending receivables over a period, divided by two.
What is high turnover of accounts receivable?
Significant turnover in accounts receivable implies that a company is promptly and effectively collecting its credit sales, showcasing cash flow management. It indicates that customers are settling their invoices promptly. A high turnover rate may hint at the company’s approach to extending credit collection methods or catering to a premium customer segment. Nonetheless, it’s crucial to factor in the context since high turnover could indicate stringent credit policies that could potentially impede sales.
What is the AR to sales ratio?
The AR to sales ratio, while not directly mentioned in the article, can be inferred as a measure related to the accounts receivable turnover ratio. The AR to sales ratio typically compares the amount of accounts receivable to the total sales within a specific period, indicating how much of a company’s sales are made on credit. However, the most directly discussed ratio in the article is the accounts receivable turnover ratio, which is calculated using net sales and average accounts receivable, rather than directly comparing AR to sales in a simple fraction.
