The accounts receivable turnover ratio is a financial ratio that measures how efficiently a company collects its accounts receivable. It is calculated by dividing net credit sales by average accounts receivable.
A higher accounts receivable turnover ratio indicates that a company is collecting its accounts receivable quickly and efficiently.
A lower accounts receivable turnover ratio indicates that a company is taking longer to collect its accounts receivable. This can be a sign of problems with the company's credit policies or its collection process.
This guide will break down what the accounts receivable turnover ratio is, why it's important and how to calculate and use it.
What is an accounts receivable turnover ratio?
Accounts receivable turnover is a financial ratio that measures how efficiently a company collects its accounts receivable. It is calculated by dividing net credit sales by average accounts receivable.
Why should businesses measure their AR turnover ratio?
There are several reasons why businesses should measure their accounts receivable turnover ratio:
- To assess the efficiency of their credit and collection policies: A high accounts receivable turnover ratio indicates that a company is collecting its accounts receivable quickly and efficiently. This can be a sign of effective credit policies, payment terms, and a robust collection process.
- To identify potential problems with their credit and collection policies: A low accounts receivable turnover ratio can indicate that a company is taking longer to collect its accounts receivable. This can be a sign of problems with the company's credit policies or its collection process.
- To compare their performance to other businesses in their industry: The accounts receivable turnover ratio can be used to compare a company's performance to other businesses in its industry. This can help a company identify areas where it can improve its credit and collection policies.
- To make informed decisions about their credit and collection policies: The accounts receivable turnover ratio can be used to make informed decisions about a company's credit and collection policies. For example, a company with a low accounts receivable turnover ratio may need to tighten its credit policies or improve its collection process.
Accounts receivables turnover ratio formula
If you're asking ‘what is the receivables turnover ratio formula?’ here is a detailed explanation:
The accounts receivable turnover ratio formula is:
Accounts Receivable Turnover Ratio = Net Credit Sales / Average Accounts Receivable
Where:
- Net Credit Sales = Total sales on credit - sales returns and allowances - sales discounts
- Average Accounts Receivable = (Beginning Accounts Receivable + Ending Accounts Receivable) / 2
AR turnover formula calculation example
To help turn the dry numbers above into something more understandable, here is an example of how you might use the AR turnover formula:
Here's an example of how to calculate the accounts receivable turnover ratio:
Assume the following information:
- Net credit sales (not cash sales): $1,000,000
- Beginning accounts receivable: $200,000
- Ending accounts receivable: $300,000
Step 1: Calculate the average accounts receivable
Average accounts receivable = (Beginning accounts receivable + Ending accounts receivable) / 2
= ($200,000 + $300,000) / 2
= $250,000
Step 2: Calculate the accounts receivable turnover ratio
Accounts receivable turnover ratio = Net credit sales / Average accounts receivable
= $1,000,000 / $250,000
= 4
Interpretation:
In this example, the accounts receivable turnover ratio is 4. This means that the company collects its owed payments from customers an average of 4 times per year. This is considered to be a good accounts receivable turnover ratio.
How to calculate accounts receivable turnover in 5 steps
To help you calculate your accounts receivable turnover, here is the process broken down into five easy steps:
- Gather the necessary information. You will need the following information to calculate your accounts receivable turnover ratio:
- Net credit sales
- Beginning accounts receivable
- Ending accounts receivable
- Calculate the average accounts receivable. The average accounts receivable is calculated by adding the beginning and ending accounts receivable from an accounting period and dividing by 2.
- Calculate the accounts receivable turnover ratio. The accounts receivable turnover ratio is calculated by dividing net credit sales by average accounts receivable.
- Interpret the results. A higher accounts receivable turnover ratio indicates that a company is collecting its accounts receivable quickly and efficiently. A lower accounts receivable turnover ratio indicates that a company is taking longer to collect its accounts receivable.
- Use the accounts receivable turnover ratio to make informed decisions. The accounts receivable turnover ratio can be used to make informed decisions about a company's credit and collection policies. For example, a company with a low accounts receivable turnover ratio may need to tighten its credit policies or improve its collection process.
Analyzing Your AR Turnover Ratio: What Is a Good Accounts Receivable Turnover Ratio?
The accounts receivable (AR) turnover ratio is a financial metric that measures how efficiently a company collects its accounts receivable. It is calculated by dividing net credit sales by average accounts receivable. A higher AR turnover ratio indicates that a company is collecting its accounts receivable quickly and efficiently, while a lower AR turnover ratio indicates that a company is taking longer to collect its accounts receivable.
What is a good AR turnover ratio?
There is no one-size-fits-all answer to this question, as the ideal AR turnover ratio will vary depending on the industry and the company's specific circumstances. However, a good AR turnover ratio is generally considered to be between 2 and 4.
Factors that affect the AR turnover ratio
There are a number of factors that can affect a company's AR turnover ratio, including:
- The company's credit terms
- The company's collection process
- The company's customer base
- The industry in which the company operates
- The overall economy
How to calculate average accounts receivable?
Average accounts receivable (A/R) is a measure of how much of its annual credit sales a company is owed by its customers on average. It is calculated by adding the beginning and ending accounts receivable balances and dividing by 2.
If you're wondering 'is accounts receivable an asset' Chaser has a full article covering exactly that.
Here are the steps on how to calculate average accounts receivable:
- Gather the necessary information. You will need the following information to calculate your average accounts receivable:
- Beginning accounts receivable balance
- Ending accounts receivable balance
- Calculate the average accounts receivable. The average accounts receivable is calculated using the following formula:Average Accounts Receivable = (Beginning Accounts Receivable + Ending Accounts Receivable) / 2
- Interpret the results. A higher average accounts receivable balance indicates that a company is taking longer to collect its accounts receivable. A lower average accounts receivable balance indicates that a company is collecting its accounts receivable more quickly.
Here is an example of how to calculate average accounts receivable:
- Beginning accounts receivable balance: $100,000
- Ending accounts receivable balance: $150,000
Average Accounts Receivable = ($100,000 + $150,000) / 2
Average Accounts Receivable = $250,000 / 2
Average Accounts Receivable = $125,000
In this example, the average accounts receivable balance is $125,000. This means that the company is owed an average of $125,000 by its customers.
How to improve your AR turnover ratio
Companies can employ a multifaceted approach to elevate their AR turnover ratio to help optimizing their financial health and operational efficiency. These strategies include:
- Implementing strict credit policies: Implementing conservative credit policies for granting credit to customers can mitigate the risk of late payments and bad debts. This may involve conducting more thorough credit checks, reducing credit limits, and shortening payment terms in an accounting period.
- Improving the collection process: A proactive and systematic approach to collections can significantly reduce the number of overdue accounts. This can include sending timely reminders, making follow-up calls, offering multiple payment methods, and escalating collection efforts when necessary.
- Offering early payment discounts: Incentivizing customers to pay their invoices early can accelerate cash flow and reduce the average collection period. This can be achieved by offering a small discount for payments made within a specified timeframe.
- Providing flexible payment options: Accommodating customers' diverse payment preferences can encourage prompt payment and foster goodwill. This may involve offering online payment options over a period of time, accepting credit cards, or establishing payment plans.
- Automating the accounts receivable process: Leveraging technology to streamline and automate AR tasks can minimize errors, save time, and improve efficiency. This can include using accounting software to generate invoices, track payments, and send reminders.
- Regular customer communication and account reconciliation: Maintaining open lines of communication with customers and conducting periodic account reconciliations can help identify and resolve billing discrepancies promptly, preventing potential payment delays.
- Clear and concise invoicing: Ensuring invoices are accurate, easy to understand, and include all relevant information can minimize confusion and disputes, facilitating timely payment.
- Utilizing Factoring or invoice financing: In certain situations, companies may consider selling their outstanding invoices to a third party (factoring) or using them as collateral for a loan (invoice financing) to improve cash flow.
- Performance tracking and analysis: Regularly monitoring key AR metrics, such as days sales outstanding (DSO), turnover days, aging of receivables, and accounts payable vs accounts receivable, can provide valuable insights into the effectiveness of collection efforts and reduce outstanding debt. It also improves the accuracy of balance sheet forecasts.
By adopting a combination of these strategies, businesses can optimize their AR turnover ratio, enhance healthy cash flow, and strengthen their overall financial position.
Key takeaways
- The accounts receivable turnover ratio measures how efficiently a company collects its accounts receivable.
- A higher accounts receivable turnover ratio on an income statement indicates that a company is collecting its accounts receivable quickly and efficiently, while a lower ratio indicates that it is taking longer to collect.
- A good accounts receivable turnover ratio is generally considered to be between 2 and 4.
- Factors that affect the accounts receivable turnover ratio include credit policies, collection process, customer base, industry, and overall financial stability.
- Average accounts receivable is a measure of how much money a company is owed by its customers on average and is calculated by adding the beginning and ending accounts receivable balances and dividing by 2.
FAQs
What are the main factors that affect the accounts receivable turnover ratio?
The accounts receivable turnover ratio is influenced by the company's credit policies, collection process, customer base, industry, and the overall economy.
Should the AR turnover ratio be high or low?
The accounts receivable (AR) turnover ratio should be high. A high AR turnover ratio indicates that a company is collecting its accounts receivable quickly and efficiently, which means that the company has a strong cash flow and is able to use its assets effectively. A low AR turnover ratio, on the other hand, indicates that a company is taking longer to collect its accounts receivable, which can lead to cash flow problems and financial difficulties.
What does it mean when an accounts receivable turnover ratio is high?
A high accounts receivable turnover ratio means that a company is collecting its accounts receivable quickly and efficiently. This is generally considered a good thing, as it indicates that the company is able to convert its sales into cash quickly. A high accounts receivable turnover ratio can also be a sign that a company has a strong credit policy and an effective collections process.
When is the AR turnover ratio used?
The accounts receivable turnover ratio is used to measure how efficiently a company collects its accounts receivable. It can be used to make informed decisions about a company's credit and collection policies, such as tightening credit policies or improving the collection process.
What are the limitations to the accounts receivable turnover ratio calculations?
The accounts receivable turnover ratio is a useful tool for evaluating a company's credit and collection practices, but it has limitations. It doesn't consider the quality of the accounts receivable, can be distorted by seasonal factors and changes in accounting policies, and doesn't provide information about the company's cash flow. Despite these limitations, it's still a valuable metric when interpreted with consideration of its shortcomings.
