Business is about money. If you offer credit, you want your money returned to you. If you lend out money to a friend, at some point, you will ask for it back, right? The same applies to your business. The calculation of the accounts receivable turnover ratio is how successful you are at doing this.
Accounting in business is full of calculations, some extremely useful and other mind-numbingly mundane.
One that you may find meaningful and valuable to your business is calculating your accounts receivable turnover ratio.
If your business extends credit, the money will need to be collected at some point.
This calculation will assist you in working out how well the company is doing in collecting the credit it has issued.
It will also allow you to predict cash flow trends and bring bad debt to your attention.
What is this magic formula? Let's take a closer look.
What is the accounts receivable turnover ratio?
This calculation will show you how effective your business is at lending out and then collecting your money in simple terms.
In theory, the higher your accounts receivable turnover ratio is, the more efficient your company is at collecting its debt.
This ratio also shows how effective a company's credit policies and procedures are and if your accounts receivable system is streamlined.
Investors use the accounts receivable turnover ratio to decide where to invest their money.
If you are looking into any future financing, having this information to hand will be beneficial.
When comparing two similar companies, an investor may choose that with the higher numbers on paper.
It makes good business sense, right?
Pros and cons
As with all things, there are pros and cons to calculating your accounts receivable turnover ratios.
The pros are that you will have a better idea of your cash flow predictions and address any customer payment issues.
It will also help you to be aware of where your company stands in their current credit policies and whether there should be any changes made at any point.
The cons are that it is an additional report that needs to be run and extra information to be captured regularly.
It also requires investigation into why the ratio is too low or too high, and this could be time spent on other things.
It boils down to your priorities and how much time your team has to crunch these numbers.
There are also a few limitations to what information can be brought to your attention and a few things that can throw out the final amounts.
Customers who pay incredibly fast or incredibly slowly may blur the final number on your turnover ratio.
Furthermore, you have to take great care about your start and endpoints of the average.
Knowing your ratios does not help you spot payment trends with your customers and cannot help with bad customer reviews.
It would be best if you weighed up the pros and cons against whether you feel that knowing your AR turnover ratio is beneficial for your business – maybe you have limited or no issues with customer payments at all, then there is no need to spend time on these calculations.
There are three easy steps in the calculation of your accounts receivable turnover ratio:
- Calculate the average accounts receivable.
- Identify your net sales.
- Divide your net credit sales by your average accounts receivable balance.
And there you have your AR turnover ratio.
Calculate your average accounts receivable
Average accounts receivable is the balance that is owed to your company over some time – usually a year.
This amount is calculated by adding the balances at the start and the end of the specific period and dividing this total by two.
If you use accounts receivable software, many of them will let you print a balance sheet report to give you these figures.
Identify net credit sales
Your net credit sales are the amounts of the net revenue generated that your business extents as a credit to customers.
This excludes amounts for return of products, allowances, and cash sales. You can pull this information in a profit and loss report or an income statement.
Divide your net credit sale by average Accounts Receivable
Once you have obtained your two figures, you will calculate the accounts receivable turnover ratio.
Use the net credit sales and divide this amount by the average AR balance.
The amount you are left with is your accounts receivable turnover ratio.
What does this amount mean?
Now that you have completed the calculation, you have an amount for your accounts receivable turnover ratio.
But what does it indicate for your business?
As mentioned previously, the resulting calculation showed how successfully your company extends credits and collects debts.
It focuses on your systems and procedures and their efficacy.
A high AR turnover ratio
If you have a high AR turnover ratio, this indicates that the systems you have in place for your accounts receivable are solid and work for your company.
This shows the following:
- You receive your debt payments on time which improves your cash flow
- You have successful debt collection methods
- You have the right customers who take credit from you – you don't have issues with bad debt
- Your customers repay their debt efficiently, which frees up money for other purchases.
High ratios are reasonable but beware of them being too high. Yes, there can be too much of a good thing!
This could indicate that your collection or credit policies may be too aggressive.
This can cause problems such as unhappy customers and missed sales opportunities with customers who have lower credit.
A low AR turnover ratio
Should you have a low AR turnover ratio, this can mean it may be time to tighten up some procedures, or even that you do not have a credit policy in place at all. A low turnover ratio can be because of any of the following reasons:
- Lack of efficient collection policies
- You are too lenient with the credit the company is giving out
- Your customers are in trouble and cannot afford to make repayments, meaning fewer future purchases
- Bad debt is causing cash flow issues.
Alternatively, this could mean that your company has issues outside of bad debt collection procedures.
Unsatisfied customers for reasons such as errors in delivery or faulty products can cause returns in a product which will cause a low turnover.
How to improve AR turnover ratio
If your company has a low AR turnover ratio, there are few things for you to work on to improve this.
Three of these are:
- Invoice customers promptly. Send out invoices within a day or two of the work or goods being provided. The longer you take to send out an invoice, the longer customers will take to pay
- Send out email reminders. A simple email reminder a few days before the invoice is due. People have a lot to remember, and that little email can make all the difference. These can be done manually or automatically, depending on your systems and workflow procedures
- Accept online payments. Giving customers the option to click on a link and pay online means they can pay immediately when opening up the email.
What is a good AR turnover ratio?
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, they collect their accounts receivable balances roughly 15 times throughout the year.
When looking at your AR ratio, one thing to keep in mind is not to compare your company to others outside of your industry.
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. Who needs that stress?
Always compare within the same industry if you need to make a comparison.
While the idea of knowing your accounts receivable turnover ratio may seem like important information, it is really up to the individual business to decide if it benefits them.
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.
At the same time, your company may not be in a position to need this information, and it can tie up time and resources that can be used elsewhere.
This being said, it is a great way to keep an eye on your credit systems, especially if you are working with good accounting software programmes that do much of the hard work for you.
If you would like further information on AR turnover ratios and how you can better manage yours, please request a call-back from one of our friendly staff.
Our intelligent, automated systems can help you to streamline procedures and basically – make the awful parts of your accounting processes someone else's problem.
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