An Ultimate Guide to Accounts Receivable Turnover Ratio

Managing accounts receivable is a cornerstone of healthy business operations, but it comes with its fair share of challenges. For businesses of all sizes, balancing timely payments from customers while maintaining strong relationships can often feel like walking a tightrope. Late payments, cash flow issues, and inefficiencies in the collection process are just a few hurdles companies face in this area.

This is where the accounts receivable turnover ratio plays a crucial role. As a key financial metric, it helps businesses measure how efficiently they collect payments and convert outstanding credit sales into cash. By understanding and optimizing this ratio, organizations can uncover insights into their credit policies, customer payment behaviors, and overall financial health.

This guide delves into everything you need to know about the accounts receivable turnover ratio, including its calculation, interpretation, and strategies to improve it, empowering businesses to strengthen their cash flow and operational resilience.

What is the Accounts Receivable Turnover Ratio?

The accounts receivable turnover ratio quantifies how a business collects its average accounts receivable balance. Furthermore, it measures a business's efficiency in collecting outstanding client balances and managing its line of credit process. A productive business has a higher accounts receivable turnover ratio, while an inefficient business has a lower ratio. This metric is frequently used to compare businesses in the same industry to see if they are on par with their competitors. Following are some of the main key guides for accounts receivable turnover ratio:

• The accounts receivable turnover ratio is an accounting metric that quantifies how well a business collects receivables from its customers
• The ratio counts the time receivables are converted to cash over a period
• A high ratio might indicate that corporate collection practices are effective, with high-quality customers who pay their bills on time
• A low ratio could result from inefficient collection processes, insufficient credit policies, or customers who are not financially viable or creditworthy
• Investors should be aware that some businesses calculate their ratios using total sales rather than net sales, which may inflate the results

How to Figure Out Accounts Receivable Turnover Ratio?

Accounts receivable are like short-term, interest-free loans that companies give their customers. For example, if a company sells to a client, it could extend the terms by 30 or 60 days, giving the client 30 to 60 days to pay for the product. The accounts receivables turnover ratio shows how quickly a business can collect its debts or the credit it gives customers. The ratio also shows how often a company's receivables are turned into cash over a certain period. The accounts receivables turnover ratio can be worked out once a year, thrice, or monthly. Your company will benefit a lot from figuring out this ratio. This number helps the accountant in:

• Figuring out how well a business is at getting paid
• How money is growing
• Getting a sense of the average amount due for the year
• Allowing you to compare the accounts with those of other companies
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Account Receivable Turnover Formula

If the accounts receivable turnover ratio needs to be written into the business's books, it must first be calculated. The ratio between net credit sales and average accounts receivable is called the accounts receivable turnover ratio. The following is the formula to determine your business's accounts receivable turnover ratio.

Net Credit Sales

The number in the accounts receivable turnover ratio numerator is net credit sales. This is the amount of money a business earns that is paid for on credit. This number includes cash sales, which don't affect accounts receivable. Net credit sales also include discounts or returns from customers. Net credit sales are calculated by taking gross credit sales and subtracting these reductions. A consistent time frame must be used in the calculation. So, the net credit sales should only include a certain time frame (i.e., net credit sales for the second quarter only). But if returns happen in the future, this number should be added to the calculation because it concerns the task being looked at. Net credit sales are those in which the cash is collected later. Therefore, net credit sales are calculated as follows: Sales on credit - Sales returns - Sales allowances.

Average Accounts Receivable

The average balance of accounts receivable is used as the number in the ratio of accounts receivable turnover. This is usually found by taking the average of the beginning and ending balances of a company's accounts receivable. Companies with more complicated accounting information systems may find it easy to get their average accounts receivable balance at the end of each day. The company can then take the average of these balances, but it needs to be aware that daily transactions can change the average. Also, the average accounts receivable balance should only cover a certain period, just like how net credit sales are calculated. Average accounts receivable is calculated by dividing the sum of starting and ending accounts receivable over a while (such as monthly or quarterly) by two.

Methods for Calculating the Accounts Receivable Turnover Ratio

Step 1: Calculate Your Net Credit Sales

The primary part of the accounts receivable turnover formula calls for net credit sales or all of the sales made on credit during the year (as opposed to cash). Therefore, this estimate should include the total credit sales minus any returns or allowances. As a result, we should be able to locate the net credit sales figure in the annual income statement or Profit & Loss account.

Step 2: Determine the Average of Your Accounts Receivable

Once we have the net credit sales figure, the average accounts receivable is necessary for the second portion of the accounts receivable turnover formula. Accounts receivable are the funds owed to a company by its customers. To calculate the average accounts receivable, add the number of accounts receivable at the start of the year to the value of your accounts receivable at the end of the year and divide by two. Then, on the balance sheet, we should be able to find the necessary accounts receivable numbers.

Step 3: Make Use of the Accounts Receivable Formula

We can use the accounts receivable turnover formula once we have these two values. The net credit sales will then be divided by the average accounts receivable to calculate the accounts receivable turnover ratio, or rate.

How to Calculate Accounts Receivable Turnover Ratio

XYZ is a bicycle and biking equipment retailer. Because cash sales are declining, the CEO decides to offer credit to all of his customers. There were $100,000 in gross credit sales and $20,000 in returns in the fiscal year ending December 31, 2019. However, the year's beginning and ending accounts receivable were $5,000 and $10,000, respectively. The CEO is curious about how frequently his company collects its average accounts receivable over the year.

As a result, XYZ Bikes Shop collected its average accounts receivable 5.4 times during the fiscal year ending December 31, 2019.

Accounts Receivable Turnover in Days: The accounts receivable turnover in days reflects the average days it takes a customer to pay the company for credit sales. The accounts receivable turnover in days formula is as follows:

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‍Accounts Receivable turnover in days = 365 / Receivable turnover ratio

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‍Calculating the accounts receivable turnover in days for XYZ Bikes Shop in the preceding example: Accounts Receivable turnover in days = 365 / 5.4 = 67.59

‍As a result, the average customer takes 51 days to repay their debt to the store.

If XYZ Bikes Shop has a policy for credit payments, such as a 30-day policy, the receivable turnover in the days calculated above would indicate that the average customer pays late.

XYZ Bike Shop December 31, 2019, Gross Credit Sales: $10,000, Returns: $20,000, Accounts Receivable, Beginning of the year $5,000 Accounts Receivable, End of the year: $10,000, Accounts Receivable Turnover Ratio: 10.66, Accounts Receivable Turnover Ratio in Days: 67.59

Strategies to Improve Accounts Receivable Turnover Ratio in Businesses

Improving the accounts receivable turnover ratio is vital for maintaining strong cash flow and financial stability. Below are practical strategies businesses can implement to enhance their efficiency in collecting payments:

1. Optimize Invoicing Procedures

Use automated invoicing systems to send accurate and timely bills. This reduces errors, ensures faster delivery, and minimizes delays in the payment cycle.

2. Establish Clear and Consistent Payment Terms

Define payment expectations upfront by setting explicit terms, including due dates, late payment penalties, and incentives for early payments, to encourage timely settlements.

3. Implement Early Payment Incentives

Offer discounts or incentives for customers who settle invoices before the due date. This can motivate clients to prioritize your payments over others.

4. Adopt Robust Credit Policies

Evaluate the creditworthiness of new customers before extending credit. Set appropriate credit limits and regularly review them to mitigate risks associated with late or defaulted payments.

5. Follow Up Proactively

Establish a system for regular follow-ups on outstanding invoices. Friendly reminders and timely communication can prompt customers to pay sooner.

6. Leverage Technology for Payment Collection

Utilize online payment platforms or automated payment systems that simplify the process for customers and speed up transactions.

7. Monitor and Analyze Accounts Receivable Data

Regularly track and analyze accounts receivable turnover ratios to identify trends and address inefficiencies. Use these insights to refine collection strategies and policies.

8. Outsource Collections When Necessary

For persistently overdue accounts, consider outsourcing to professional collection agencies. This approach ensures that the focus remains on core business operations while recovering unpaid debts.

Following Up

Payment reminders don't have to come only when a payment is late. Instead, think about calling or emailing your customers ten days before the invoice is due to remind them that they need to pay. Then, as soon as the due date has passed, follow up.

Conclusion

A high accounts receivable turnover ratio indicates effective collection and strong cash flow, while a low ratio suggests inefficiencies and potential liquidity issues. Managing the accounts receivable turnover ratio can be complex, as it requires tracking and managing invoices, following up on overdue accounts, and maintaining customer relationships. Companies often turn to third-party providers to optimize the accounts receivable turnover ratio.

Invensis offers specialized accounts receivable services using advanced software to streamline the collection process. Our software automates invoicing, tracks outstanding payments, and sends timely reminders to clients, ensuring quick and efficient collections. We provide real-time insights into cash flow, enabling businesses to make informed financial decisions. Our services include dispute management, customer communication, and reporting, helping companies reduce DSO (Days Sales Outstanding) and improve overall financial health. Contact us to enable businesses to focus on growth while we handle the complexities of accounts receivable management.