Accounts receivable turnover is the number of times per year that a business collects its average accounts receivable. The ratio is intended to evaluate the ability of a company to efficiently issue credit to its customers and collect funds from them in a timely manner. A high turnover ratio indicates a combination of a conservative credit policy and an aggressive collections department, as well as a number of high-quality customers. A low turnover ratio represents an opportunity to collect excessively old accounts receivable that are unnecessarily tying up working capital. Low receivable turnover may be caused by a loose or nonexistent credit policy, an inadequate collections function, and/or a large proportion of customers having financial difficulties. It is also quite likely that a low turnover level indicates an excessive amount of bad debt. It is useful to track accounts receivable turnover on a trend line in order to see if turnover is slowing down; if so, an increase in funding for the collections staff may be required, or at least a review of why turnover is worsening.
To calculate receivables turnover, add together beginning and ending accounts receivable to arrive at the average accounts receivable for the measurement period, and divide into the net credit sales for the year. The formula is as follows:
Net Annual Credit Sales ÷ ((Beginning Accounts Receivable + Ending Accounts Receivable) / 2)
For example, the controller of ABC Company wants to determine the company's accounts receivable turnover for the past year. In the beginning of this period, the beginning accounts receivable balance was $316,000, and the ending balance was $384,000. Net credit sales for the last 12 months were $3,500,000. Based on this information, the controller calculates the accounts receivable turnover as:
$3,500,000 Net credit sales ÷ (($316,000 Beginning receivables + $384,000 Ending receivables) / 2)
= $3,500,000 Net credit sales ÷ $350,000 Average accounts receivable
= 10.0 Accounts receivable turnover
Thus, ABC's accounts receivable turned over 10 times during the past year, which means that the average account receivable was collected in 36.5 days.
Here are a few cautionary items to consider when using the receivables turnover measurement:
- Some companies may use total sales in the numerator, rather than net credit sales. This can result in a misleading measurement if the proportion of cash sales is high, since the amount of turnover will appear to be higher than is really the case.
- A very high accounts receivable turnover number can indicate an excessively restrictive credit policy, where the credit manager is only allowing credit sales to the most credit-worthy customers, and letting competitors with looser credit policies take away other sales.
- The beginning and ending accounts receivable balances are for just two specific points in time during the measurement year, and the balances on those two dates may vary considerably from the average amount during the entire year. Therefore, it is acceptable to use a different method to arrive at the average accounts receivable balance, such as the average ending balance for all 12 months of the year.
- A low receivable turnover figure may not be the fault of the credit and collections staff at all. Instead, it is possible that errors made in other parts of the company are preventing payment. For example, if goods are faulty or the wrong goods are shipped, customers may refuse to pay the company. Thus, the blame for a poor measurement result may be spread through many parts of a business.
The accounts receivable turnover ratio can be used in the analysis of a prospective acquiree. When the ratio is excessively low, an acquirer can view this as an opportunity to apply more vigorous credit and collection practices, thereby reducing the working capital investment needed to run the business.
Accounts receivable turnover is also known as the debtor's turnover ratio.