The business terrain has always been and will continue to be very challenging. It has been estimated that around 1 in 5 startups end up closing shop in their very first year of existence. One key reason for this is poor financial management. Businesses that survive and last very long not only invest in and update their bookkeeping/accounting knowledge but also use various accounting tools, techniques, and concepts to ensure they are in the best possible financial state. One such useful concept is the accounts receivable turnover ratio.
So what is an accounts receivable turnover ratio, and why is it important? This post will not only answer this crucial question but also shed light on related areas such as the accounts receivable formula, accounts receivables turnover ratio formula, receivable days, trade receivables collection period formula, and more.
The accounts receivable turnover ratio (ARTR), also known as receivable turnover ratio, debtors turnover ratio, or trade receivables turnover ratio is an efficiency or activity ratio that measures the number of times a business collects its average accounts receivable balance from clients over a specific period. It is a quantification of how efficiently and quickly a business is collecting revenue as well as how it is managing its line of credit.
Learning how to calculate accounts receivable turnover ratio is important because if a company’s receivables turnover is overlooked or not properly managed over a significant length of time, there could be an increased likelihood of the company failing to frequently and accurately bill customers or remind them of the money they owe. This can increase the risk of not receiving payments on time for delivered products and/or services and even bad debt, both of which can hurt the company’s finances.
Basically, the accounts receivable turnover ratio serves a couple of crucial purposes
The formula for how to calculate accounts receivables turnover ratio (ARTR) is net credit sales (NCS) divided by average account receivables (AAR).
Account receivables turnover ratio formula = Net credit sales ÷ Average accounts receivable.
Net credit sales is the difference between gross credit sales and other sales transactions such as cash sales, sales returns, sales discounts, sales allowances, etc.
Net credit sales formula = Gross credit sales – any (or all of) cash sales, sales returns, sales discounts, and sales allowances.
Average accounts receivable is the summation of the period’s (e.g., monthly, quarterly, annually) starting and ending accounts receivables.
Accounts receivable formula (or trade receivables formula) = Starting accounts receivables + ending accounts receivables.
Company A sells wedding items and allows certain customers to purchase on credit. The company accumulated $180,000 in gross credit sales for the accounting period. Other sales transactions during that time include cash sales of $30,000, sales returns of $4,500, and a $1000 sales allowance. The starting and ending accounts receivables for the period were $9,000 and $10,000 respectively. Therefore the debtors turnover ratio for the one-year period will be:
Accounts receivable turnover ratio = $180,000 - $30,000 - $4,500 - $1000 ÷ ($9,000 + $11,000)/2 = 14.45
This outcome means that Company A collected its receivables 14.45 times on average that year. To know how well it performed for that year, the company can compare the results of previous periods to see whether 14.45 times is an improvement or otherwise.
Understanding the importance of how to calculate accounts receivable turnover ratio on receivable days is imperative. The receivable days or trade receivables days is a concept used to determine the average number of days it takes a customer to pay the company for items purchased on credit (that is, the receivables collection period). It is calculated with the receivable days formula.
Here is the trade receivable days formula:
Receivable days = 365/Receivable turnover ratio
For the above example, the accounts receivable turnover in days will be
365 ÷ 14.45 = 25.17
This receivable days formula result means that it takes an average of 25 days to pay for a credit purchase. If the company has a 30-day billing policy (often known as “net 30” in the US), then it implies that, on average, the customers pay up on time.
As noted above, the account receivable turnover ratio is an efficiency ratio that helps a company gauge how well it is doing in certain parameters. If you've been wondering about how to interpret your ratio, the insight below will help.
Ensuring your company promptly collects outstanding credit debt from customers is good for its financial health since it will help the company remain liquid enough to take care of its payment needs. However, it must be noted that the accounts receivable turnover ratio is a contextual metric, meaning that it varies according to industry. Nonetheless, you should always target higher ratios since they create a positive outlook for your company in the eyes of funding sources such as investors or financial institutions.
In other words, a high receivables turnover ratio can signal efficiency when it comes to having a quick trade receivables collection period as well as an indication that a company has honest, caring, and/or financially strong customers who take the company’s interests at heart and therefore strive to settle their debts promptly.
A high receivables turnover ratio can also be due to a company's tight or conservative credit access policy. Though conservative credit policies can help companies avoid toxic debt and late-paying customers, a very tight or conservative credit policy can make a company lose out on potentially favorable deals and clients. Such clients can opt to transact with competitors that are more credit-friendly. In this sense, it may be better for a credit-conservative company lagging on sales to loosen its credit policy in order to improve sales, even with the risk of a lower accounts receivable turnover ratio.
Generally speaking, a low accounts receivables turnover ratio is not considered good for a company, mainly because it creates the impression of inefficiency, ineffective credit policies, and dishonest or incapable customers. One message a low accounts receivable turnover sends to affected companies is the need to take another look at their credit policies with a view to making necessary changes and also evolving ways of optimizing their collection process.
However, there are times when a low receivable turnover ratio isn’t as bad as it's usually interpreted. Therefore, truly understanding How to calculate accounts receivable turnover ratio is very useful. For instance, when a company’s product distribution department is inefficient, there may be a slow delivery of goods to customers which may also cause payment delays on the part of customers and, hence, a decrease in the company’s accounts receivables turnover ratio.
Now let's discuss the key factors affecting how to calculate accounts receivable turnover ratio and how to analyze them. The higher the number, the better a company is perceived, since it implies that your company has a sound credit policy that makes for timely payments from clients and efficient collection of sales debt.
A higher account receivable turnover ratio can also be an indication of optimal cash flow, a sound balance sheet or income statement, balanced asset turnover, and greater creditworthiness for a company. But this may not always be the case.
For a business that has yet to figure out how to improve receivable and day ratios, the answers are simple. By understanding how to calculate accounts receivable turnover ratio you can improve your receivable and day ratios by implementing changes that can improve your trade receivables collection period. You can also encourage early payments by providing incentives, such as discounts, to customers who pay early.
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