Accounts receivable turnover ratio definition
/What is the Accounts Receivable Turnover Ratio?
Accounts receivable turnover is the number of times per year that a business collects its average accounts receivable. The ratio is used to evaluate the ability of a company to efficiently issue credit to its customers and collect funds from them in a timely manner. It is one of the most important measures of collection efficiency.
Understanding the Accounts Receivable Turnover Ratio
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.
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.
Related AccountingTools Courses
Since the accounts receivable turnover ratio is one of the better measures of accounting efficiency, it should be included in the performance metrics for the accounting department on an ongoing basis. It is also useful for monitoring the overall level of working capital investment, and so is commonly presented to the treasurer and chief financial officer, who use it to plan funding levels.
How to Calculate the Accounts Receivable Turnover Ratio
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. Net credit sales are those sales generated on credit, minus all sales returns and allowances. The formula is as follows:
Net Annual Credit Sales ÷ ((Beginning Accounts Receivable + Ending Accounts Receivable) / 2)
Example of the Accounts Receivable Turnover Ratio
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. Assuming that ABC’s normal credit terms were 30 days to pay, the 36.5 days figure represents quite an acceptable collection rate.
How to Improve Your Accounts Receivable Turnover Ratio
There are several ways to improve the accounts receivable turnover ratio, all involving alterations to the company’s collection policies and procedures. They are as follows:
Conduct Error Checking
Use an error-checking routine to ensure that all invoices are accurate. This may call for a cross-check by a second invoicing clerk. Otherwise, customers will reject invoices, especially if the amounts billed are too high.
Bill Immediately
Always bill customers immediately after goods have been delivered or services performed. Otherwise, payment will be delayed. Billing on the same day as the date of goods or service delivery is ideal.
Send Invoices Electronically
Send invoices by email, with a link that allows customers to pay at once with a credit card. This approach eliminates mail float. A variation is to load your invoice into a customer’s electronic payment portal.
State Payment Options
Clearly state the payment options on the invoice (such as paying by phone or on an Internet site), as well as the exact date on which payment is due. It may also help to remove extraneous information from the invoice that customers do not need, thereby leaving more room for them to see the payment terms.
Make Follow-Up Calls
Make follow-up calls to customers who have received larger invoices, to settle any questions they may have. These calls should be made soon after invoices are sent, so that any billing issues are fresh in the minds of customers. Otherwise, customer issues may delay payment. This is especially useful for customers that have a habit of paying late.
Offer Discounts
If the company really needs the cash, then offer an early payment discount. However, the effective interest rate associated with early payment discounts can be quite high, so be judicious in offering discounts to customers. One way to tackle discounts is to offer them selectively on just a few high-dollar invoices, where you are fairly sure that the customer will take the deal. Doing so keeps most customers from seeing the offer, which can be associated with a business that is in financial difficulty.
Problems with the Accounts Receivable Turnover Ratio
Here are a few cautionary items to consider when using the receivables turnover measurement:
Total Sales Used
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. This is a particular concern in businesses that generate a robust amount of cash sales in proportion to their credit sales.
Restrictive Credit Policy Used
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 creditworthy customers, and letting competitors with looser credit policies take away other sales. A restrictive credit policy is not a good idea when product margins are high, since it can result in the loss of a substantial amount of profit. In this case, it would be better to loosen the credit policy in order to increase sales to lower-quality customers, since the incremental amount of profit gained will exceed the incremental gain in bad debts.
Denominator Calculation Method
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. Whatever averaging method is used should be consistently applied.
Seller Mistakes Causing Nonpayment
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. If so, be sure to drill down into the reasons given by customers for non-payment, and forward this information to senior management for further action.
Receivables Turnover vs. Asset Turnover
The receivables turnover measurement clarifies the rate at which accounts receivable are being collected, while the asset turnover ratio compares a firm’s revenues and assets. The asset turnover metric is useful for evaluating the efficiency with which management is employing a company’s assets to generate sales. A higher asset turnover rate implies that a company is being run in an efficient manner. However, an undue focus on the asset turnover measurement can also drive managers to strip assets out of a business, to the extent that it has less capacity to deal with surges in customer demand.
Terms Similar to Accounts Receivable Turnover Ratio
Accounts receivable turnover is also known as the debtor's turnover ratio.