When you lend money to a friend, you do so on the assumption that it will be paid back within a reasonable time frame. If they do not make an effort to repay you, you will ask for this money back yourself.
This debt collection process is similar to the way in which businesses ensure they are properly paid for their services or products. This is known as your accounts receivable turnover.
The calculation of your accounts receivable turnover ratio, therefore, shows how successful your billing and collections methods are.
As such, while business accounting can be both mundane and complex, calculating your accounts receivable turnover ratio is an important task when it comes to improving your cash flow and financial standing. After all, if your business extends credit, the money will need to be collected at some point. Otherwise, you'll be draining your business accounts without bringing in any profit, which could put your business on the path to premature closure.
Not only will calculating your accounts receivable ratio help you to determine how well your company is performing fiscally, it can also bring bad debt to your attention. As such, you're then able to make important changes to your company's credit policies that will remedy this moving forward.
This article will explain in detail the importance of managing your accounts receivable turnover, providing valuable advice on how to calculate your turnover ratio. Finally, it will provide you with tips for improving your accounts receivable turnover ratio for the betterment of your business.
What is the accounts receivable turnover ratio?
In simple terms, accounts receivable turnover ratio is a calculation that assesses how effective your business is at lending out and then collecting your money. This is based on metrics such as your net credit sales average and overall collections rates.
In theory, the higher your accounts receivable turnover ratio is, the more effective your company is at collecting outstanding debt. Conversely, a lower accounts receivable turnover ratio suggests that your practices are ineffective and in need of reshaping.
This ratio also shows how effective a company's credit policies and procedures are and if your accounts receivable system is streamlined.
Potential investors will also use your accounts receivable turnover ratio when determining how they'd like to invest their money. As such, if you are trying to secure financing, having your receivables turnover ratio formula can prove to be beneficial. It could actually be the difference between a company choosing to work your brand over a competitor.
What is a good accounts receivable turnover ratio rate?
As mentioned above, a higher number is an indication that you have developed a good accounts receivable turnover, though the exact figure can vary depending on the nature of your work. However, the exact accounts receivable turnover ratio you should be aiming for will be explored in more detail towards the end of the article.
Pros and cons
As with any business procedure, it's important that you weigh up the pros and cons of the task before you dedicate your time and energy to completing it.
There are certain pros and cons associated with calculating your accounts receivable turnover ratios. This includes:
Pros:
- You can use your receivables turnover ratio to improve your cash flow predictions. This, in turn, can help you to grow your business from strength to strength.
- You can use your ar turnover ratio to address customer payment issues and find new ways to encourage customers to pay on time. For example, this could include offering discounts for early payments or splitting larger sums into smaller, more manageable amounts.
- You can use your accounts receivables turnover ratio to gain a deeper understanding of where your company stands in its current credit policies and address whether or not changes need to be made to your payment terms or invoicing practices moving forward.
Cons:
- While the accounts receivable turnover formula is not necessarily a complex one, it's something that you must calculate fairly regularly in order to ensure the data is accurate and up to date. As such, this can take up a lot of time that could be dedicated to other tasks, such as customer communication. It may also be particularly challenging for staff who do not have a background in accounting.
- You must conduct an investigation into the reasoning behind high or low accounts receivable turnover ratios, which could interrupt daily business practices. Following this, you must then begin to implement changes that improve your accounts receivable turnover rate, and it can sometimes take a lot of time to find a strategy that works.
Typically, your decision whether or not you decide to figure out your accounts receivable turnover ratio boils down to your priorities and how much time your team has to crunch these numbers. If you are busy working on other projects, you may decide to ignore your receivable turnover ratio altogether.
The limitations
There are also a few limitations as to what information can be brought to your attention when calculating your accounts receivable turnover ratio and a few things that could throw off the final amount.
For example, customers who pay incredibly fast or incredibly slowly may blur the final number on your receivables turnover ratio. This is because these anomalies can skew data, meaning the calculation you land on may not be the most accurate. As such, you may want to omit these payments before you begin to calculate your accounts receivable turnover ratio.
Furthermore, you have to take great care about your start and endpoints of the average to ensure that the data collected is as accurate as possible.
Beyond this, knowing your ratios and ensuring that your company collects the money it is owed does not help you spot payment trends with your customers and cannot help with bad customer reviews. This is something that you'll have to work on independently.
It's best to weigh up the aforementioned pros and cons against whether you feel that knowing your accounts receivable ar turnover ratio is beneficial for your business. For example, if you're lucky enough to have no issues with getting customers to pay invoices, then there is no need to spend time on these calculations.
However, given that 87% of businesses report that their invoices are not paid on time, having an understanding of your accounts receivable turnover can be incredibly useful when it comes to actioning meaningful change. This way, you can make sure that you are getting paid on time.
The calculations
Fortunately, calculating your accounts receivable turnover is relatively simple. Here, the accounts receivable turnover ratio formula is broken down into three easy steps:
- Calculate the average accounts receivable
- Identify your net sales
- Divide your net credit sales by your average accounts receivables balance.
Once you've followed this guide, you'll land on your accounts receivable AR turnover ratio.
Calculate your average accounts receivable
Your average accounts receivable refers to the exact balance that is owed to your company over a specific accounting period - usually a year. You can calculate your average accounts receivable by adding the balances at the start and end of the accounting period together and dividing the total by two.
If your company utilises any accounts receivable software, you should be able to generate a balance sheet report that will automatically provide you with these figures.
Identify net credit sales
Your net credit sales are the amounts of the net revenue generated that your business extends as credit to customers. This excludes the amounts for product returns, allowances, and cash sales.
You can find data relating to your net credit sales in a profit and loss report or in your income statement.
Divide your net credit sale by average Accounts Receivable
Once you've gathered these two figures, you can begin to calculate your accounts receivable turnover ratio. This is calculated by dividing the net credit sales amount by the average AR balance.
The final figure reflects your accounts receivable turnover ratio.
What does this amount mean?
Once you've completed your calculations, you'll have uncovered your accounts receivable turnover ratio. However, it's important that you then use this data to your advantage by determining what your accounts receivables turnover ratio means for your business.
As mentioned previously, this figure is reflective of how successful your company is at extending credit and collecting debt. It can highlight vital flaws in your systems and procedures that are costing you money or harming your bottom line.
A high AR turnover ratio
If you have a high turnover ratio, congratulations! This indicates that the company has solid systems in place and that your accounts receivable work for your company.
A high accounts receivable turnover shows the following:
- Your debt payments are paid on time, which improves your cash flow
- You have successful debt collection methods in place, or your company collects payments quickly and promptly.
- You have the right customers who take credit from you
- You don't have issues with bad debt or extending credit
- Your customers repay their debt efficiently, freeing up money for other purchases and increasing your net sales
While high ar turnover rates are beneficial, you should also be wary of them being too high. Yes, there can be too much of a good thing. For example, an incredibly high accounts receivable turnover rate could indicate that your collection or credit policies may be too aggressive.
This could lead to numerous problems, such as customer dissatisfaction and missed sales opportunities among customers with lower credit. After all, being overly aggressive in your collection methods often translates into poor customer service, and "86% of customers stop doing business with a company because of bad customer service," which could lead to a loss of income moving forward.
A low AR turnover ratio
A low accounts receivable turnover ratio indicates that there is a need for tighter procedures when it comes to asset turnover, sales on credit, and client payments as a whole. Alternatively, your low AR turnover ratio also indicates that the company has no credit policy in place at all, which is something you must address quickly.
A low ratio can triggered by any of the following:
- A lack of efficient collection policies, which drastically impact your cash flow or the rate at which your clients pay their invoices or bills.
- You are too lenient with the credit your company is giving out
- Your customers are in trouble and cannot afford repayments, meaning fewer future purchases
- Bad debt is causing additional cash flow issues within your business
- You're dealing with a lot of product or customer returns, resulting in a low turnover.
If you believe that your accounts receivable turnover ratio is too low and is negatively impacting your business, then you must take action to better your accounts receivable.
How to improve AR turnover ratio
Fortunately, there are many things you can do to improve a low ratio. This includes:
- Invoice customers promptly. Send out invoices for customers to pay within a day or two of the work being provided. As the interaction is still fresh in their mind, they're likely to pay quickly and without question. Typically, the longer you take to send out an invoice, the longer getting paid will take.
- Sending out email reminders. Sending out a simple email reminder a few days before the invoice is due can go a long way toward improving your receivable ratio. You can send these out manually or have an automated system in place. You may also benefit from sending email reminders when invoices have not been paid on time.
- Accept online payments. Providing customers with a range of different payment options can also help you go about improving your accounts receivable turnover ratio. For example, being able to pay online means they can pay immediately when opening up the email. However, you may want to consider more traditional payment options such as cheques and bank transfers.
- Setting clear payment terms. If you do not establish clear payment terms and expectations with your clients ahead of time, this can reflect in the number of days it takes for a client to pay an invoice. This is a conversation that should take place before you even begin to work on a project. For example, you should tell the client that you expect the invoice to be paid within a specific timeframe and make clear that there are penalties in place for late payments.
- Send out detailed invoices. Detailed invoices that include a complete breakdown of the work completed or the number of hours spent on a particular project also ensure the client understands the payment terms. This means they are less likely to dispute or question your invoice, meaning that you'll get paid quickly. As such, it can be a great way to improve your accounts receivable turnover ratio.
In short, when you're looking to better your accounts receivable turnover ratio, you simply need to work on improving your billing and collections processes.
What is a good AR turnover ratio?
As mentioned above, the rule of thumb is the higher your AR turnover ratio, the better. For example, a turnover of 10 is not as good as that of 15.
If your company has an AR ratio of 15, this means that they collect their accounts receivable balances approximately 15 times annually.
However, there's no exact answer to the above question. This is because your ideal turnover ratio is also industry-dependent, which means that you should only be looking to others in your industry as a point of comparison.
After all, every industry has its credit and debit traits, and if you look outside of this to make a comparison, you may think that your company is falling short. For example, AR turnover ratios within clothing companies are vastly different to those within B2B businesses. As such, you should use the average accounts receivable rate within your business when looking for guidance on whether or not you need to make changes. You can usually find information on the average accounts receivable rate within your industry online.
In summary
While the idea of knowing or calculating your accounts receivable turnover ratio may seem like crucial information, it is really up to the individual business to decide if this knowledge will benefit them. For example, you may want to focus your attention on other tasks, such as improving your customer relationships, developing new products, or reducing staff turnover in order to improve your bottom line.
However, having this information on hand can highlight gaps in your policies and procedures that can free up cash flow and assist you with debt collection and customer relationships. It's also a great way to keep an eye on your credit systems, especially if you are working with good accounting software programs that do most of the hard work on your behalf.
If you would like more information on turnover ratios or would like to find out how turnover ratio is used to propel your business to success, please request a call-back from one of our friendly staff.
The intelligent, automated systems from Chaser can help you streamline your procedures and make even the most complex of accounting processes seem as easy as possible to handle.
