Accounts Receivable Turnover Ratio: What It Means and How To Calculate It
Updated February 15th 2023
A guide explaining the Accounts Receivable Turnover Ratio meaning, how to calculate it, and its limitations.
What is Accounts Receivable Turnover Ratio?
The accounts receivable turnover ratio measures how effective a company is in converting its accounts receivable into cash within an accounting period. It calculates the frequency at which a company deals with its average accounts receivable over a certain period.
Importance of Accounts Receivable Turnover Ratio
Keeping a close eye on accounts receivable is key for any business. This can help you track how you handle incoming payments and it will make it easier to budget and plan more accurately for the future. It's also helpful to ensure bills are paid on time.
The ratio allows businesses to check whether their credit strategies and procedures help steady cash flow and sustained progress.
How it Works
Accounts receivable is like a free loan given by businesses to their customers. If a company makes a sale, they can let the customer take one to two months before they have to pay - so 30 or 60 days.
The receivables turnover ratio is a way to measure how effectively and quickly a business is collecting payments from customers. It tells how efficient the company is when it comes to dealing with its credit activities. The ratio looks at how often a company gets paid in a certain period. It's calculated every year, quarter, or month and shows how reliable their customers are.
Formula and Calculations
AR Turnover Ratio is worked out by dividing the figure from your net sales by the average accounts receivable. Net sales are ascertained by subtracting the amount of sales returns and discounts from your total credit sales. To calculate the average account receivable, you add up the starting and ending receivables for a certain period (say, monthly, quarterly, or annually) and divide by two.
Use the accounts receivable turnover formula to figure out the AR turnover rate for a full year:
Net Annual Credit Sales ÷ Average Accounts Receivables = Accounts Receivables Turnover
High vs. Low Calculation
A high accounts receivable turnover ratio usually suggests that the company doesn't give out credit too easily and is serious about collecting payments. It may also mean that the company's customers are reliable or that it works primarily on a cash basis.
But this can also be a problem. If a firm is too strict with giving credit, it could hurt its revenue as competitors could end up attracting potential customers. Companies must weigh the pros and cons of having a lower ratio to sustain themselves when times get tough.
A low ratio could point to mismanagement, giving out credit too easily, spending excessively on operations, and potentially serving a financially unstable customer base. It might also be down to larger economic situations.
Limitations of the Ratio
There are some limitations to the accounts receivable turnover ratio. You should take into account the industry that you're in before using this ratio. Grocery stores, for example, often have a high Accounts Receivable turnover ratio because of their point of sale-focused nature, so it doesn't reflect how well the store is running.
Factories tend to have low ratios because of the long payment periods associated. So, to get a better idea of what this group's ratio means, it needs to be examined in its context. The ratio calculated gives an idea of the overall payment behaviour, but it doesn't show who may be close to bankruptcy or if people are switching over to competitors. It can also not tell you who your best customers are.
If you have a seasonal business, it's possible your ratio could be influenced by the opening and closing balances of your accounts receivable. One can look at the average accounts receivable over a year (12 months) to balance out any seasonal dips.
- The accounts receivable turnover ratio is used to measure how well a company manages its average receivables over a certain period. It tells you how quickly the company can collect its debt.
- To figure out how long it usually takes customers to pay their debts, divide 365 by the accounts receivable turnover ratio. This calculation gives you the accounts receivable turnover in days - an average number of days for customers to settle their bills.
- A fast turnover rate is always a good sign as it could mean that the company is good at collecting payments, has plenty of clients, or has tight credit policies in place.
- Having a low accounts receivable turnover isn't a good sign for businesses and usually shows poor collection methods, offering extended credit to customers who shouldn't receive it, or having excessively lenient payment policies.
What Is the Accounts Receivable Turnover Ratio in Days?
The accounts receivable turnover in days is a measure of how quickly customers repay the money they owe for credit sales. It tells us the average number of days it takes customers to settle their payments.
To calculate accounts receivable turnover in days, use this formula:
Receivable turnover in days = 365 ÷ Receivable turnover ratio
What Is a Good Accounts Receivable Turnover Ratio?
Generally, the higher the number, the better - it means your payments are arriving on time and your business is effective at collecting.
If your company's numbers are high, it can mean better cash flow, a good balance sheet and income statement, balanced asset turnover, and improved creditworthiness.
Should the Accounts Receivable Turnover Ratio Be High or Low?
A high accounts receivable turnover ratio is better as it shows that a company can convert its accounts receivables into cash quickly. This provides them with more money to use for operations or growth-related activities.
What Affects the Accounts Receivable Turnover Ratio?
The Accounts Receivable Turnover Ratio is calculated using Net Credit Sales and Accounts Receivable. Companies can improve this ratio by being careful to whom they offer credit and also by dedicating internal resources to collect any unpaid invoices.
How do you calculate bad debt expense?
Bad debts are unavoidable, but you can use the percentage of the bad debt expense formula to estimate it ahead of time. This is done by dividing your previous bad debts by your previous credit sales.
The bad debt formula is:
Total bad debts ÷ Total credit sales = Percentage of bad debt
Updated February 15th 2023
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