The accounts receivable turnover ratio measures how efficiently your company collects debts.
This formula directly impacts your cash flow.
- A high ratio means that you’ve successfully collected more of what your customers owe you.
- A low ratio means that your customers owe you money you haven’t collected.
Failure to maintain a favorable accounts receivable turnover ratio can mean even though your sales activity is good, your cash flow is underperforming. Left unchecked, this can lead to cash-flow crunches that potentially jeopardize your company’s financial solvency even if everything else is going well.
To avoid getting blindsided by a cash-flow crisis, it’s important to know how to track and manage your accounts receivable turnover ratio. Here’s a closer look at the definition of the ratio, how to calculate it, how to interpret it and what steps you can take to improve it.
What Is the Accounts Receivable Turnover Ratio?
Your accounts receivable turnover ratio, also known as a receiver turnover ratio or debtor’s turnover ratio, is an efficiency ratio that measures how quickly your company extends credit and collects debt. It does this by comparing your net credit sales (net receivable sales) to your average accounts receivable (average net receivables) for a given period.
Net Credit Sales and Average Accounts Receivable Defined
Your net credit sales represent the number of sales that are paid on credit extended by your company rather than paid in cash. Your average accounts receivable represents the amount of money that your debtors owe your company.
(Note: This doesn’t mean all sales made using credit cards from companies such as Mastercard and Visa but rather sales made using a line of credit extended by your own company.)
The accounts receivable turnover ratio is usually calculated on an annual basis, using net credit sales and annual average accounts receivable. It also can be calculated over a shorter interval, such as a quarter or a month. This can be useful if you want to know how efficiently you collect debts for sales made during the holiday shopping season compared with other times of the year.
Why It Matters
Knowing your accounts receivable turnover ratio can help you with financial planning by letting you know if you should anticipate a cash-flow lag between the time sales are made and the time sales revenue actually comes in. It can let you know if you need to take steps to improve your credit policy or debt-collection efficiency.
How to Calculate Accounts Receivable Turnover Ratio
The accounts receivable turnover ratio formula is simple to calculate. You need to know two key numbers:
- Your net credit sales over the selected period
- Your average accounts receivable for the same period
Determine Your Net Credit Sales
You can influence your net credit sales by taking total sales on credit and subtracting sales returns (credit issued to customers as a result of customer-service issues). You can also use sales allowances, or price reductions issued to customers as a result of service issues.
The easiest way to keep track is by entering cash and credit sales separately into your books at the time of purchase as well as creating separate entries for returns and allowances. Note that your net credit sales are normally entered on your income statement and can be taken from this.
About Average Accounts Receivable
Average accounts receivable, the other crucial number, is determined by adding accounts receivable at the beginning of a given period to accounts receivable at the end of the same period and dividing by two.
Accounts receivable typically is recorded on your balance sheet and can be derived from this.
Time to Do the Math
Once you know your net credit sales and average accounts receivable, you simply divide them to get your ratio:
Net credit sales / average accounts receivable = accounts receivable turnover ratio
You can calculate this manually or use an online accounts receivable turnover ratio calculator.
Let’s say, for example, your company’s annual net credit sales are $200,000 and your average accounts receivable for the same year is $50,000. Dividing $200,000 by $50,000 gives you an accounts receivable turnover ratio of 4. This means that you collect the average amount of accounts receivable you are owed 4 times a year, the equivalent of once a quarter.
You may express an annual accounts receivable turnover ratio in terms of days by taking 365 and dividing by your accounts receivable turnover ratio. This tells you how long the average customer takes to repay their debt to you.
Interpreting Your Accounts Receivable Turnover Ratio
Once you know your accounts receivable turnover, you can analyze the results. In general, the higher your ratio, the faster you’re collecting what your customers owe you. A high accounts receivable turnover ratio indicates that you’re:
- Getting repaid quickly
- Screening customer creditworthiness
- Collecting debts effectively
In contrast, a decrease in accounts receivable turnover ratio indicates:
- Slow debt repayments
- Extending credit without due diligence
- Ineffective debt collection procedures
What is a reasonable accounts receivable turnover ratio depends on the context. For instance, if your business operates primarily on a cash basis, you’ll tend to automatically have a high ratio. If you have very tight credit policies, you’ll also have a very high ratio, but you could be missing sales opportunities by not extending credit more widely to potential customers.
To determine what your ratio means for your company, track your ratio over time to see whether it goes up or down – and how that correlates with factors like sales volume and cash flow.
Consider your own business goals
If you’re finding your cash flow is frequently tight, you might want to consider whether improving your accounts receivable turnover ratio could help your cash flow.
What constitutes a good ratio also varies by industry, so it can be useful to compare your company’s ratio with those of your peers.
Improving Your Accounts Receivable Turnover Ratio
How do you go about improving your accounts receivable turnover ratio? There are strategies you can use to raise or lower your score:
- Changing the amount of time you allow customers to repay debts can increase or decrease your ratio.
- Changing your credit extension policy to tighten or loosen qualifications can change your ratio.
- Being more proactive with debt collection can increase your ratio.
If you find you have a low accounts receivable turnover ratio and require cash flow even while you’re seeking to collect your debts, one option is to pursue accounts receivable financing.
What is Accounts Receivable Financing?
This is a type of financing in which your lender extends you credit based on accounts receivable that you expect to collect at a future date. This option allows you to tap into money you have coming in the future and put it to use now financing your business.
Finding Your Success Ratio
Your accounts receivable turnover ratio measures how efficiently you collect money your customers owe you. It’s calculated by dividing your net credit sales by your average accounts receivable over a given period.
- A high or increasing ratio can mean that your customers are repaying you quickly, you have good credit screening policies or you have efficient debt collection procedures.
- A low or decreasing ratio can mean your customers are slow to repay you, you have relaxed credit extension policies or you have inefficient debt collection procedures.
You can adjust your ratio by changing how much time you give customers to repay you, by changing your credit qualifications or by pursuing debt collection more proactively.
If you need to offset a low accounts receivable turnover ratio, accounts receivable financing from Fast Capital 360 can help you maintain cash flow while you’re waiting to collect. Get approved today by applying online, or call one of our funding experts at (800) 735-6107 to discuss your financing needs.