What is the Accounts Receivable Turnover Ratio? Formula & Examples
 Finance & Accounting

What is the Accounts Receivable Turnover Ratio? Formula & Examples

Rick Johnson
Rick Johnson
November 22, 2023
Last updated on:

November 22, 2023

|

Read time: 7 mins

Accounts Receivable Turnover Ratio, a crucial financial metric, serves as a barometer of a company's efficiency in managing its credit sales and collecting outstanding payments from customers within a specific period. This fundamental ratio unveils the effectiveness of a company's credit policies, showcasing how swiftly it converts credit sales into cash.

Understanding the intricacies of the accounts receivable turnover ratio is crucial for businesses aiming to enhance cash flow management, identify potential financial risks, and optimize their credit and collection strategies.

This blog delves into the calculation and examples of this vital financial metric for businesses.

According to Mordor Intelligence, the account receivable automation market size will be USD 2.72 Billion in 2023and is anticipated to reach USD 4.76 Billion by 2028 at a CAGR of 11.84 %.

Accounts Receivable Turnover Ratio Explained

The accounts receivable turnover ratio is a prime financial metric that measures a company's effectiveness in managing its receivables. It indicates how many times, on average, a company collects its accounts receivable during a specific period.

A higher turnover ratio usually signifies that a business is promptly collecting payments from its customers, demonstrating a more efficient and effective credit and collection process. Conversely, a lower ratio might indicate potential issues, such as difficulties in collecting payments or inefficient credit policies.

For instance, consider a theoretical company, ABC Electronics, that manufactures and sells electronic devices. In a given year, ABC Electronics generated $5 million in credit sales. Over the same period, the average accounts receivable balance was $1 million. By dividing the total credit sales of the business by the average accounts receivable balance, the company's ART ratio is 5. This suggests that ABC Electronics collects its outstanding receivables five times a year or every 72 days on average.

Accounts Receivable Turnover Ratio Explained

How to Calculate Accounts Receivable Turnover Ratio for Businesses

The accounts receivable turnover ratio can be calculated by the below formula:

Accounts Receivable Turnover Ratio = Net Credit Sales/Average Accounts Receivable

Let's break down the components of this formula and delve into the steps involved in calculating the ratio.

Net Credit Sales:

This represents the total sales made on credit during a specific period, minus any returns or allowances. It is essential to focus only on credit sales because the ratio is designed to evaluate the efficiency of collecting payments from credit customers.

Net Credit Sales = Total Sales − Returns − Allowances

Average Accounts Receivable:

To calculate the average accounts receivable, add the beginning and ending accounts receivable for a specific period and divide the sum by 2.

The beginning accounts receivable is the amount of receivables at the start of the period, while the ending accounts receivable is the amount at the end of the period.

Now, let's delve into the significance of the formula components:

Average Accounts Receivable = (Beginning Accounts Receivable + Ending Accounts Receivable) / 2

Net Credit Sales:

This figure reflects the company's ability to generate sales on credit terms. High net credit sales can be positive, but it also means the company is extending credit to its customers, and the efficiency of collecting on those sales becomes crucial.

Average Accounts Receivable:

The average accounts receivable represents the average amount of outstanding receivables during a given period. A lower average indicates that the company is collecting payments quickly, which is favorable for cash flow.

The accounts receivable turnover ratio is a major tool for several reasons:

Efficiency of Receivables Management:

A higher ratio suggests that the company is collecting payments quickly, indicating effective credit and collection policies. Conversely, a lower ratio may signal issues with credit terms or collection procedures.

Cash Flow Management:

A high turnover ratio implies that the company is converting receivables into cash rapidly, positively impacting cash flow. This is crucial for meeting short-term obligations and making strategic investments.

Credit Risk Assessment:

The ratio aids in evaluating the credit risk associated with the company. A low turnover ratio may indicate a higher likelihood of default or delayed payments from customers.

What does a higher receivables turnover mean for a business?

A higher receivables turnover indicates that a business efficiently collects outstanding payments from customers within a shorter period. This signifies strong cash flow, improved liquidity, and effective credit policies. It reflects streamlined operations, reduced risk of bad debts, and potential for increased sales due to prompt receivables management.

To learn the effective ways of improving your accounts receivable turnover, read our blog, 'How to Increase Accounts Receivable Turnover.’

Accounts Receivable Turnover Ratio for Businesses

Examples of Accounts Receivable Turnover Ratio

The following are a few examples of how accounts receivable turnover ratios can be used.

Example 1: Calculating the Ratio:

To illustrate the calculation of the accounts receivable turnover ratio, let's consider a hypothetical company, ABC Inc. If ABC Inc. has total credit sales of $1,500,000 and average accounts receivable of $300,000 during a year, the ratio would be calculated as follows:

This result suggests that, on average, ABC Inc. collects its outstanding receivables five times during the year.

Example 2: Industry Comparison:

Comparing the accounts receivable turnover ratio of a company to industry benchmarks or competitors can provide valuable insights. For instance, if ABC Inc. operates in the technology sector, where quick cash cycles are common, a ratio of 5 might be considered low. This could indicate that ABC Inc. takes a longer time to collect its receivables compared to industry norms. On the other hand, in industries with traditionally longer sales cycles, a ratio of 5 might be deemed acceptable.

Example 3: Trend Analysis:

Analyzing the accounts receivable turnover ratio over multiple periods helps identify trends. If ABC Inc. had a ratio of 6 in the previous year and now it's 5, there might be a concern. A declining ratio could signify issues with credit policies, customer payment behaviors, or economic factors affecting the industry. Management should investigate the reasons behind the decline and take corrective actions if necessary.

Example 4: Credit Policy Evaluation:

The accounts receivable turnover ratio is closely linked to a company's credit policy. Suppose ABC Inc. decides to relax its credit terms to boost sales. As a result, the average accounts receivable might increase, leading to a lower turnover ratio. While this could stimulate short-term sales, it may also expose the company to a higher risk of bad debts and cash flow issues in the long run. Monitoring the ratio helps evaluate the impact of credit policy changes on overall efficiency.

Example 5: Collection Efforts and Efficiency:

Companies that effectively manage their accounts receivable often have a higher turnover ratio. For instance, if ABC Inc. implements more efficient collection procedures, such as timely follow-ups on overdue invoices, offering discounts for early payments, or using technology for automated invoicing, the average accounts receivable balance could decrease, positively impacting the turnover ratio.

Conclusion

The evolution of technology will significantly impact the accounts receivable turnover ratio. Automation and advanced software will streamline invoicing, payment processing, and data analysis, potentially accelerating the turnover ratio. However, challenges arise with technology implementation, including initial investment costs, system integration issues, and data security concerns.

Delegating AR management to third-party providers can offer advantages. Specialized agencies adeptly handle collections, reducing the Days Sales Outstanding (DSO) and improving the accounts receivable turnover ratio. Businesses benefit from expertise, cost savings on infrastructure, and increased focus on core operations. It also mitigates technological adoption risks and ensures efficient AR management, positively impacting the turnover ratio.

Invensis is a specialized finance and accounting company offering comprehensive accounts receivable services. Our expertise in collections, streamlined processes, and advanced technology optimizes AR turnover. With a dedicated focus on efficient management, we ensure reduced DSO, improved liquidity, and enhanced financial performance for businesses. Contact us today to optimize your accounts receivable and improve your business's cash flow.

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