The Accounts Receivables Turnover Ratio Helps Business Leaders Identify Problem Customers & Optimize Cash Flow
Managing accounts receivable isn’t for the faint of heart. AR professionals are responsible for collecting the money your company is owed by customers, vendors, or other entities. If the payer doesn’t get the funds to your organization in a timely manner, it could put your entire business in jeopardy. Businesses cannot provide goods or services without getting paid for them – that’s one of the first facts of doing business.
Tracking the amount of time it takes for customers to pay their bill is a key reporting priority within the accounts receivable function. The AR team has to know if a payer is delinquent with their payments, if the contract terms aren’t being upheld, or if the customer’s line of credit should be tightened or removed altogether.
One of the main calculations that AR experts – which play a different part than your AP team – lean on when making these decisions is the Accounts Receivable Turnover Ratio. If you’re not recalculating the receivables turnover ratio on a regular basis, you’re leaving your company open to vulnerabilities and unnecessary risk. Luckily, using the receivable ratio turnover formula in your business is fairly straightforward and something that can be implemented right away.
What is the Accounts Receivable Turnover Ratio?
The accounts receivable turnover ratio showcases how many times your organization successfully collects the average balance in the accounts receivable section of your balance sheet. This is money you are owed, and it’s critical that invoices are being settled regularly.
Essentially, AR can be thought of as a line of credit; you aren’t going to keep extended credit if a client isn’t paying you back in a timely manner. While you might think you’ll never deal with a difficult client who isn’t paying what they owe, the fact of the matter is, there are many businesses and individuals out there who will force you to tighten your relationship with them because of this very issue.
In the same way it’s important for your organization to optimize the supplier payments process to vendors, you want to collect payments seamlessly when you’re in the supplier role. The more efficient your company is at managing receivable turnover, the higher the ratio will be. Keep in mind that the account receivable turnover is dependent on the industry you’re in. In some industries, it’s normal to have net30 payment terms with customers while in others, customers may have a longer window to pay the credit they have been given. Since these factors will impact the receivables turnover ratio, you should only compare your output to other businesses in your industry – your competitors.
When to Use the Accounts Receivable Turnover Ratio
The receivable turnover formula should be used regularly at specific time intervals. Many companies calculate their AR turnover ratio on a monthly, quarterly, and yearly basis to get a snapshot of how efficient their AR process is. The turnover ratio can be calculated on an overall, holistic level, or it can be used at an individual client level to isolate delinquent clients and the rate at which they have been paying their balance.
Accounts Receivable Turnover Formula
To get an accurate accounts receivable turnover ratio, you need to know the net credit sales and the average accounts receivable within the period you’re measuring.
- Net Credit Sales: The amount of revenue your business has earned via credit will end up being the net credit sales amount, your numerator when calculating the accounts receivable turnover ratio. You must subtract sales discounts or customer returns from the net credit sales figure within that specific period to get an accurate starting point.
- Average Accounts Receivable: On the bottom of the equation – the denominator – you’ll have the average accounts receivable. This is the result of adding the ending accounts receivable balance to the starting accounts receivable balance and dividing it by 2.
Formulaically, use the below equations for your receivable ratio turnover formula:
- Net Credit Sales = Gross Credit Sales – Refunds or Returns
- Average Accounts Receivable = (Starting AR Balance + Ending AR Balance) / 2
- Accounts Receivable Turnover Ratio = (Net Credit Sales / Average Accounts Receivable)
- AR Turnover in Days = 365 / Accounts Receivable Turnover Ratio
With the above formulas, your organization can better forecast the flow of funds you’ll have coming into your business. These funds can then be used to cover business expenses, strategic investments, or other financial commitments. Let’s see how this calculation plays out in practice:
- Your company has net credit sales of $600,000 annually after all the refunds and discounts are factored in.
- Your AR starting balance was $75,000 and your AR ending balance in the period was $60,000. This means your average accounts receivable is (75,000 + 60,000) / 2 = $67,500.
- With this information, you can figure out your accounts receivable turnover ratio. $600,000 / $67,500 = 8.89
Interpreting Accounts Receivable Turnover Ratio
Deciding whether or not the outcome of your accounts receivable turnover ratio is “good” can be fairly nuanced. The results of the receivables turnover ratio will vary depending on a variety of factors. The following items can all impact the ratio output within a period:
- Industry standards for payment terms
- The credit policies your organization has
- Economic volatility
- Customer behavior
When assessing the results of the receivables turnover ratio, be sure to factor the context of the above items into your assessment.
High vs. Low AR Turnover Ratio
When it comes to the accounts receivable turnover ratio, higher is better. In the above example, the company in question turned its accounts receivable into cash 8.89 times in a single year. If you divide 365 / 8.89, you can see that it took an average of 41.06 days to collect funds from customers. If your payment terms are N30, you need to tighten your credit policies with your customers and aim for a 30-day turnover result if possible.
If your receivable turnover ratio is low, it means that you’re not successfully collecting debts often enough. When left uncollected, debts impact your company’s liquidity and ability to operate. Training your accounts receivable team can go a long way in recouping overdue invoice payments.
Ideal AR Turnover Ratio
As mentioned, the result of an accounts receivable turnover ratio formula can vary widely, and so can your company’s tolerance for these fluctuations. Ideally, your receivables turnover ratio in number of days should line up with your net payment terms. If most of your payment terms are N30, aim for an AR turnover ratio of 10 to 12, signaling that you collect payments every 30 to 36 days on average.
Limitations of Receivables Turnover Ratio
Data points without context are about as helpful as no data at all, and account receivable turnover is no different. When you analyze this metric, be sure to look at metrics that measure your liquidity, your overall sales, and your collection process, all of which will give more context to the number at the end of the receivable turnover ratio formula.
If your business relies on subscriptions or cyclical payments with many different customers, your ratio could end up being a poor representation of the overall collections process. Account receivable turnover also fails to consider extenuating circumstances that your clients may face that would cause them to be delinquent in their payments to you. Perhaps a warehouse fire or cybersecurity attack is impeding their ability to pay on time; these instances are one-offs and will usually recover in the next period.
Improving Your Accounts Receivable Turnover Ratio
If your organization continues to see a low receivables turnover ratio, it’s time to make a change. It can feel a bit awkward to change payment terms or collections policies with your customer, but sometimes, it’s necessary. Try some combination of the following items if you’re not sure where to start:
- Reduce payment terms with clients. If you continue to have clients pay after the due date of their invoices, tighten the line of credit you’re offering them. Instead of allowing them to pay an invoice within 60 days, shorten it to 30, or even 15 days. If clients are repeat offenders who constantly miss payments, consider putting them on a prepayment contract. Your payment terms should be clearly listed on every invoice you send, ensuring there is no miscommunication from either side.
- Impose late fees for delinquent payments or discounts for early payments. People don’t want to pay extra fees, so if they sign a contract that tells them a 10% late fee will be added to invoices that aren’t paid on time, they’ll be inclined to get you your cash. On the other side, you could decide to reward your clients who continue to pay early. Giving a 5% discount for early payments could solidify your organization’s ability to collect on invoices with ease.
- Send payment reminders. You’d be surprised at how effective this can be. Sometimes, clients will get busy, and it’ll slip their minds to submit a payment. A few emails throughout the month as the invoice due date approaches is a seamless way to nudge them toward paying you.
- Build an automated payment infrastructure for your clients. If you offer services, consider having an automated payment option. This way, your customers won’t have to manually submit payments, and instead, with their permission, you can collect funds automatically. In the same way that automating the invoice process on the sender side can improve AP productivity, automating tasks on the AR side will improve upstream and downstream workflows.
The accounts receivable turnover formula can be a difficult one to optimize, but with a few key tricks, your organization could go from struggling with accounts receivable to seeing an exponential increase in the number of invoices cleared on time.
Using Technology to Improve the AR Turnover Ratio
An efficient and effective automated invoicing process will better the AR turnover ratio of any business. If you feel like the current resources available to your AR team aren’t cutting it, consider investing in a software solution like Nanonets that can revolutionize how your entire accounting and finance team operates. With streamlined invoice matching, the use of robotic process automation, and error-free processes, the right software can make a world of difference.