Calculating your accounts receivable turnover ratio helps you understand your business cash flow and how your credit policies affect it.
What is an accounts receivable turnover ratio?
The accounts receivable turnover ratio is a metric that assesses how quickly a business collects its payments from debtors during a specific time period, such as a month or a quarter. In essence, it compares your sales for a particular period with the amount owed to you during that time. If you calculate your accounts receivable turnover ratio monthly, you’ll be able to compare one month with another month; if you calculate the ratio quarterly, you’ll be able to compare one quarter with another quarter.
The accounts receivable turnover ratio can be used as a measure of efficiency when comparing businesses from the same or similar industries.
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 income that you’ll collect later because you’ve provided goods or services on credit. It shows the amount of sales revenue you’ve earned that’s on credit, less any returns and allowances such as a reduced price due to a problem of some sort.
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 time frame, such as monthly or the first quarter.
Average accounts receivable
Your accounts receivable are the sales invoices that your customers haven’t paid yet.
To establish the average accounts receivable, add the starting receivables and ending receivables over the chosen period of time (such as monthly or quarterly) and then divide by two. This gives you the average.
The average accounts receivable depends on the industry – it may be different for each one – and varies widely. Larger businesses also vary from smaller ones as they’re often able to offer longer credit periods due to their higher cash flow and ability to absorb more credit sales.
What does a high average accounts receivable turnover ratio mean?
A high accounts receivable turnover ratio is generally a positive sign: it may indicate that a good proportion of customers are paying their bills promptly.
A high ratio often means that a business’s credit collection process is working and it’s collecting payments from customers efficiently and regularly. A higher ratio also potentially means more is being paid by cash and fewer payments are owed. It can also mean that the business has conservative credit policies and limits the amount of credit payment options available to customers.
What does a low average accounts receivable turnover ratio mean?
A low ratio might mean that the business has inefficient credit collection policies and would benefit from adjusting them so that customers pay more promptly. It could also mean that the credit policies aren’t conservative enough. However, it is possible that it is the nature of the industry and a reflection of its customers, as opposed to a problem with policies or processes.
How important is a good accounts receivable turnover ratio to a business?
A good accounts receivable turnover ratio can be a useful indicator of how efficient your business is. Be sure to compare with your nearest similar competitors, and not businesses that are significantly bigger or smaller than yours.
A good ratio suggests that your performance at collecting credit sales is strong, and you can predict a healthy cash flow with liquidity that can provide opportunities for investment in your business.
If your ratio is low, it may indicate that you need to improve the checks you do into the creditworthiness of your customers. Or you may need to adjust your terms of doing business.
It’s good for businesses to keep an eye on the accounts receivable turnover ratio throughout the year to track performance and see projections for the future as part of their financial modeling and planning.
Disadvantages of the accounts receivable turnover ratio
The accounts receivable turnover ratio can be very industry-dependent. It may not be very effective as an indicator for businesses that depend on cash sales such as grocery stores. And some manufacturers have a longer credit payment time period, especially for big-ticket items.
The accounts receivable turnover ratio is useful for spotting trends in your business, but it doesn’t provide any details about individual customers, such as bankruptcy issues.
Any businesses that are affected by seasonal operations, such as landscapers, may have mixed accounts receivable turnover ratios that are not a reliable indicator of business efficiency. Averaging results across a year is likely to be better.
How can you use your accounts receivable turnover ratio to improve your business?
This financial ratio is a tool to help check the health of your business. The following are some tips for improving your accounts receivable turnover ratio:
- Include your customer payment terms in your contracts and on your invoices including details of your terms for late payment and the period of time to pay any outstanding debt. State your credit terms clearly and in plain language.
- Invoice your clients often and check that all details, such as dates, are accurate. Errors slow down the process and cause delays.
- Consider providing incentives for early payment before the due date, such as a discount. This encourages customers to pay their bills early.
- Use online accounting software, such as Xero to make the process easier with automation.
- Provide a variety of ways for customers to pay. For example, you can offer payment via bank transfers, credit cards and PayPal. Make it easy for clients to pay.
- Follow up and send reminders before a bill is due. Customers can be busy people and forget they have to pay your bill.
- Check your accounts receivable regularly so that you can spot any payment issues early.
Xero does not provide accounting, tax, business or legal advice. This guide has been provided for information purposes only. You should consult your own professional advisors for advice directly relating to your business or before taking action in relation to any of the content provided.
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