Accounts receivable turnover ratio: What you need to know

Published Friday 11 August 2023

Table of contents

• What is the accounts receivable turnover ratio?
• The accounts receivable turnover ratio formula
• An example calculation of the accounts receivable turnover ratio
• Pros and cons of the accounts receivable turnover ratio
• A healthy accounts receivable ratio is good for your business
• FAQs on the accounts receivable turnover ratio

Key takeaways

• The receivables turnover ratio measures how efficiently your business collects payments from customers and can help you assess your cash flow and credit policies.
• The formula to calculate the accounts receivable turnover ratio is AR turnover ratio = Net credit sales / Average accounts receivable.
• An advantage of using the ratio is that businesses can assess cash flow performance, as a high ratio shows payments are being collected efficiently and a lower ratio may reflect inefficient cash flow.
• The accounts receivable turnover ratio may not be a useful metric for cash-heavy businesses like grocery stores, or for seasonal businesses or industries with long payment cycles.

Strategies like setting clear payment terms, invoicing on time, and using automated accounting tools like Xero can help your business improve its accounts receivable turnover ratio.

Calculating your accounts receivable turnover ratio helps you understand your business’s cash flow and how your credit policies affect it. Here’s how the formula works and how the ratio can help you assess your cash flow.

What is the accounts receivable turnover ratio?

The accounts receivable turnover (or working capital turnover) ratio assesses how quickly a business collects its payments from debtors over a specific period, such as a month or a quarter. It compares your sales for a particular period with the amount owed to you during that time.

The ratio is useful for you to gauge the efficiency of your business. If you calculate your accounts receivable turnover ratio each month, you’ll be able to compare one month with another month; if you calculate the ratio quarterly, you can compare one quarter with another.

The receivables turnover ratio is often used to compare the efficiencies of businesses from the same or similar industries.

Learn more about accounts receivable

The accounts receivable turnover ratio formula

The accounts receivable (AR) turnover ratio formula is:

AR turnover ratio = Net credit sales / Average accounts receivable

Let’s look at each part of the formula:

Net credit sales

Net credit sales is the income a business earns from goods or services sold on credit, excluding any returns, allowances, or discounts. This reflects the amount of income expected to be collected later after adjusting for sales-related deductions..

The net credit formula is:

Net credit = Gross credit sales – Sales returns – Sales allowances

To calculate and compare net credit sales, you need to use a consistent timeframe, such as monthly or quarterly.

Average accounts receivable

Your average accounts receivable is the sum of the beginning and ending accounts receivable divided by two. To find this figure, use the average accounts receivable formula:

Average AR = (Beginning AR + Ending AR) / 2

The average accounts receivable depends on the industry. Larger businesses’ averages also vary from smaller ones as they can often offer longer credit periods due to their higher cash flows and their ability to absorb more credit sales.

Learn more about the process of accounts receivable

An example calculation of the accounts receivable turnover ratio

Suppose a business is calculating its turnover ratio after doing a financial statement analysis. It had the following results for the year:

• Net credit sales of $450,000
• Average accounts receivable of $40,000

Using the receivables turnover formula, the business calculates the ratio as:

AR turnover ratio = $450,000 / $40,000 = 11.25

The result is an accounts receivable turnover ratio of 11.25, which means the business collected receivables 11.25 times, on average, throughout the year.

You can take this example further and determine the average time it takes the business to collect its receivables during the year. To do this, the business would use the following calculation to determine the average collection period:

365 days ÷ 11.25 = 32.4

This shows that the business’s customers make payments every 32 days, on average. If the business has a 30-day collection period, the accounts receivable turnover of 11.25 indicates that customers are paying 2 days late on average.

Learn more about small business accounting cycles

Pros and cons of the accounts receivable turnover ratio

Calculating your accounts receivable turnover ratio and using it to analyze your small business operations and policies has many positives, but it doesn’t suit all businesses or every situation.

The advantages

• Tracking your accounts receivable turnover ratio can help you manage cash flow more efficiently because it shows how quickly or slowly customers are making their payments.
• The ratio can also provide deeper insights into your business’s credit policies, and help you identify any payment issues early on – such as frequently late payments.
• The ratio can help you benchmark your performance in your industry. Comparing your ratio with industry standards gives you a better idea of where you stand in your industry compared with its benchmarks for growth and profitability.
• A consistent and predictable turnover ratio can help you forecast incoming cash flow more accurately.
• It’s a signal to potential investors and lenders. For example, a higher ratio indicates that your business manages its finances well, making it more attractive for funding.

The disadvantages

The usefulness of the accounts receivable turnover ratio depends somewhat on your industry. It may not be a reliable indicator of your business efficiency if, for example:

• You depend on cash sales (if you run a grocery store, say)
• You’re a seasonal operation where your turnover (and therefore the ratio) can swing quite dramatically

Although the accounts receivable turnover ratio is good for spotting trends in your business, it doesn’t provide any details about your individual customers, or how their situation may affect ratio results – for example, whether they might be having financial problems.

The ratio also isn’t a comprehensive assessment of your business’s financial reports and balance sheet. For one, it doesn’t measure the effort or costs associated with collecting your receivables.If your business has to dedicate significant resources to maintaining a high ratio - such as hiring staff to manage collections or doing constant follow-ups - it may not be the most practical measure of overall financial stability.

Finally, your accounting practices can affect your ratio results. For instance, you could improve the ratio in the short term by writing off your debts or day sales outstanding – but doing so won’t reflect your actual credit or collection performance.

Learn more about managing accounts receivable

A healthy accounts receivable turnover ratio is great for your small business

Maintaining a good accounts receivable turnover ratio, (along with accounts payable turnover ratio), can help you know if your business is efficient, and therefore make improvements that will boost your business’s financial health and stability.

This ratio can help you maximize your cash flow, manage your credit, and therefore help you grow your business. It’s therefore a good idea to monitor and analyze your turnover ratio regularly.

FAQs on the accounts receivable turnover ratio

What does a high average accounts receivable turnover ratio mean?

A high accounts receivable turnover ratio over time is generally a positive sign, as it can indicate that your customers are paying their bills on time. It can also suggest you have efficient credit collection processes and fewer payments owed to you.

What does a low average accounts receivable turnover ratio mean?

A low average ratio might mean that the business has inefficient credit collection processes – and could perhaps adjust them to prompt their customers to pay up! It could also mean the business’s credit policies are too lenient, and that the business should tighten up their payment terms and credit checks. But it’s possible that a low average ratio is a feature of the industry and a reflection of its customers, rather than a problem with policies or processes.

How important is a good accounts receivable turnover ratio to my small business?

A good accounts receivable turnover ratio indicates efficient credit collection and strong cash flow, which are essential in supporting business investments. A strong accounts receivable turnover ratio also helps ensure that your business has the cash it needs to cover expenses, and avoid cash flow shortages that could disrupt operations. Poor cash flow management is one of the leading reasons most small businesses fail.

How can I use the accounts receivable turnover ratio to improve my business?

First, here are some ways to improve your accounts receivable turnover ratio. Include customer payment terms in your contracts and invoices with details of your terms for late payments and the collection period for outstanding debt. State your credit terms clearly and in plain language. Invoice your clients often and check all the details. Give customers incentives to pay early, like discounts. Use online accounting software like Xero to automate your invoicing and reconciliation processes.