Tracking accounts receivable turnover is critical for any business to monitor financial health and cash flow.
This article will explain the accounts receivable turnover formula in simple terms and provide actionable strategies to improve it.
You'll learn the definition and importance of accounts receivable turnover, walk through the formula calculation, understand turnover ratios and days sales outstanding, and discover ways to enhance billing, collection, and credit policies to optimize working capital.
Introduction to Accounts Receivable Turnover
The accounts receivable turnover ratio measures how efficiently a company collects payment from its customers. It is calculated by dividing net credit sales by average accounts receivable.
A higher turnover ratio indicates that a company is collecting payment from customers more quickly, while a lower ratio means it takes longer to collect payment. Companies want to have a high turnover, as this means they are efficiently converting receivables into cash.
Defining Accounts Receivable Turnover
The accounts receivable turnover formula is:
Accounts Receivable Turnover = Net Credit Sales / Average Accounts Receivable
Where:
- Net Credit Sales = Total credit sales - any returned goods or allowances
- Average Accounts Receivable = (Beginning A/R balance + Ending A/R balance) / 2
This measures how many times average receivables are converted into cash over a period through collections from customers.
Why Track Accounts Receivable Turnover?
Monitoring the accounts receivable turnover ratio is important because it provides insight into:
- Customer payment patterns and creditworthiness
- Effectiveness of collection procedures
- Liquidity and working capital management
- Potential issues in receivables management
By tracking this over time, companies can identify trends and take action to improve collections.
Good vs. Bad Turnover Ratios
A higher turnover generally indicates better performance. However, acceptable ratios vary widely across industries:
- Grocery: 30 times
- Hardware: 7 times
- Airlines: 5 times
As a rule of thumb, a ratio below 5 may indicate problems with collections, while above 10 is considered strong. Companies should track their own historical trends and set goals based on their business model.
How do you explain receivable turnover?
The accounts receivable turnover ratio measures how efficiently a company collects payments owed from its clients and customers. It is an important metric to assess the financial health and cash flow management of a business.
Here is a breakdown of what the accounts receivable turnover ratio tells us:
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The ratio measures how many times a company's accounts receivable balance is converted into cash over a period, usually annually.
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It is calculated by dividing net credit sales by average accounts receivable.
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A higher turnover ratio indicates a company is collecting payments from clients more frequently throughout the year. This improves cash flow.
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A lower ratio suggests poor collections performance, which can tie up capital and hurt liquidity.
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As a rule of thumb, a ratio of 3 to 6 times is considered good. Less than 3 means improvements are likely needed in credit and collections policies.
To summarize, the accounts receivable turnover ratio shows how well a company leverages and converts its accounts receivable into cash flow. Monitoring this metric can help businesses identify issues with outstanding payments and determine if changes in credit terms or collection procedures could accelerate cash inflows.
What is the formula for receivables turnover?
The accounts receivable turnover ratio formula is calculated by dividing net credit sales by average accounts receivable.
Here is the formula:
Accounts Receivable Turnover Ratio = Net Credit Sales / Average Accounts Receivable
Where:
- Net Credit Sales = Total credit sales - Sales returns - Sales allowances
- Average Accounts Receivable = (Beginning AR balance + Ending AR balance) / 2
This ratio shows how many times a company's accounts receivable turn over during a period. A higher turnover ratio indicates that a company is collecting payments from customers more quickly.
For example, if a company has $1 million in net credit sales and an average accounts receivable balance of $200,000 over a year, its accounts receivable turnover ratio would be:
$1,000,000 / $200,000 = 5
This means the company's accounts receivable turned over 5 times that year. This generally indicates efficient credit and collection policies.
The accounts receivable turnover ratio is an important metric to assess the efficiency of a company's credit and collection processes. Monitoring this ratio over time can help identify trends and opportunities to improve operational efficiency.
What does a receivables turnover of 7 times represent?
A receivables turnover ratio of 7 times means that a company collected payment on its accounts receivable balance 7 times over the course of a year. This indicates that the company is efficiently collecting payment from customers and converting accounts receivable into cash relatively quickly.
Specifically, an accounts receivable turnover of 7 times means:
- The company issued credit and collected payment on that credit at a rate equal to 7 times its average accounts receivable balance over the year.
- It took the company approximately 52 days on average to collect payment from customers (365 days / 7 turnovers = 52 days).
- The company is efficiently managing its accounts receivable. A high turnover ratio generally indicates efficient credit and collection policies.
A turnover of 7 times is usually considered relatively high and indicative of an efficient collection process. However, the optimal turnover ratio can vary significantly by industry. It's important to compare the ratio to industry benchmarks. A ratio of 7 times would be more concerning in an industry where 30 days is the norm for collecting receivables.
In summary, a receivable turnover ratio of 7 times signals that the company is converting receivables to cash quite efficiently. It points to well-managed credit issuance policies and collection procedures. Most companies aim for higher rather than lower receivables turnover, as long as credit policies remain sound.
What is the formula for calculating accounts receivable?
The accounts receivable turnover ratio formula is used to calculate how efficiently a company collects payment from its customers. Here is the formula:
Accounts Receivable Turnover Ratio = Net Credit Sales / Average Accounts Receivable
Where:
- Net Credit Sales = Total credit sales for a period - any returned goods or allowances
- Average Accounts Receivable = (Beginning Accounts Receivable + Ending Accounts Receivable) / 2
This ratio shows how many times a company's accounts receivable turn over per period. A higher ratio indicates that a company is collecting payments from customers more quickly.
For example, if a company has:
- Net credit sales of $1,000,000
- Beginning AR of $200,000
- Ending AR of $150,000
The average AR is ($200,000 + $150,000) / 2 = $175,000
The accounts receivable turnover ratio would be:
$1,000,000 / $175,000 = 5.71
This means the company is turning over its accounts receivable around 5.71 times per year. Generally, a ratio higher than 5 is considered good.
The accounts receivable turnover ratio is an important metric to assess the efficiency of a company's credit and collection processes. Monitoring this ratio over time can help identify potential issues with collections.
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Calculating Accounts Receivable Turnover
The accounts receivable turnover ratio measures how efficiently a company collects payment from its customers. It is an important metric for assessing the financial health and cash flow management of a business.
Here are the key steps to calculate accounts receivable turnover:
Find Net Credit Sales on the Income Statement
Net credit sales refers to the amount of products or services sold on credit over a period. To find this, locate the net sales or revenue on the company's quarterly or annual income statement. Net credit sales will typically make up a majority of the net sales.
Determine Average Accounts Receivable
Next, collect the accounts receivable balances from the balance sheet over the same period as the income statement. Add the beginning and ending accounts receivable for the period, and divide the sum by two to calculate the average for the period.
Plug Numbers into the Accounts Receivable Turnover Ratio Formula
The formula is:
Accounts Receivable Turnover Ratio = Net Credit Sales / Average Accounts Receivable
Take the net credit sales figure and divide it by the average accounts receivable amount just calculated. The result is the accounts receivable turnover ratio.
A higher ratio indicates more efficient collection of receivables. A lower ratio may indicate issues with collections or credit policies. Compare the ratio to industry benchmarks to better interpret the results.
Monitoring trends in the accounts receivable turnover ratio over time can provide valuable insights into the financial operations and health of a business. Pairing it with other metrics like days sales outstanding (DSO) can help diagnose working capital issues.
Understanding the Accounts Receivable Turnover Ratio in Days
The accounts receivable turnover ratio, also known as Days Sales Outstanding (DSO), is an important financial metric that measures how efficiently a company collects payment from its customers. Specifically, it calculates the average number of days it takes to turn accounts receivable into cash.
Lower DSO generally indicates more efficient credit and collection processes, while higher DSO suggests potential issues in receivables management. Tracking and benchmarking DSO can help businesses identify opportunities to accelerate cash flow.
The Receivable Days Formula
The receivable days formula calculates DSO as follows:
DSO = Average Accounts Receivable / (Total Credit Sales / Number of Days)
To break this down:
- Average Accounts Receivable = Ending AR balance from the most recent reporting period
- Total Credit Sales = Total sales made on credit over the measured time period
- Number of Days = Number of days in the reporting period, usually quarterly or annually
For example, if a company had $100,000 in credit sales over the past 90 days, and $20,000 in accounts receivable at quarter-end, its DSO would be:
$20,000 / ($100,000 / 90 days) = 18 days
This means it takes the company 18 days on average to collect payment on its credit sales.
Comparing DSO with Industry Benchmarks
Once the DSO formula is calculated, it can be compared to industry benchmarks to gauge the efficiency of a company's credit and collections process. Lower DSO relative to industry averages generally indicates more efficient receivables management.
For example, the average DSO across industries is about 40 days. So a company with a DSO of 18 days is performing favorably compared to sector norms. This could signify strong credit policies and diligent collections procedures.
Conversely, if a company's DSO is 60 days, stretching 20 days longer than average, it likely signals inefficiencies in credit extension policies or collections that should be addressed.
Linking DSO to Cash Flow Management
The faster a business can collect from customers, the sooner it can convert receivables to cash in hand. Higher DSO directly translates to reduced liquidity and constrained cash flow.
For example, Company A with a DSO of 30 days can convert receivables to cash in half the time it takes Company B with a 60 day DSO. All else being equal, Company A will have substantially improved cash flow compared to Company B.
There are several strategies companies can use to reduce DSO and improve cash flow:
- Tightening credit policies to work with more creditworthy customers
- Optimizing billing procedures to issue invoices promptly
- Following up on past due accounts to accelerate collections
- Offering discounts for early payment
- Accepting credit cards to get paid faster
By regularly monitoring DSO and taking steps to lower it closer to industry norms, companies can unlock working capital and strengthen their cash positions.
Using an Accounts Receivable Turnover Calculator
Introducing tools and software to automate the calculation of accounts receivable turnover can provide businesses with valuable insights into financial and operational performance.
Selecting the Right Calculator
When choosing an accounts receivable turnover calculator, it's important to select one that:
- Integrates with your existing accounting systems and workflows
- Provides real-time tracking of turnover metrics
- Allows customization of formulas and benchmark targets
- Offers clear visualizations of trends over time
Opt for a calculator that is easy to set up, user-friendly, and offers robust reporting functionality.
Integrating with Accounting Information Systems
Integrating a turnover calculator with accounting information systems like QuickBooks can provide:
- Automatic population of sales and accounts receivable data
- Real-time updates when new invoices are issued or payments received
- On-demand access to turnover ratios without manual calculations
This streamlines the process of assessing accounts receivable performance and identifying opportunities for improvement.
Analyzing Results with Financial Analysis Courses
Taking financial analysis courses can help build expertise in interpreting accounts receivable turnover trends. Key topics include:
- Benchmarking ratios against industry standards
- Assessing impacts of turnover changes on cash flow
- Identifying root causes driving ratio fluctuations
- Developing strategies to optimize working capital
Ongoing analysis enables businesses to fine-tune credit policies and collection procedures in support of growth and profitability goals.
Strategies for Improving Your Accounts Receivable Turnover
Improving accounts receivable turnover requires a multi-pronged approach focused on optimizing credit policies, payment incentives, billing procedures, and data-driven decision making.
Review and Adjust Credit Policies
Carefully evaluating credit terms, limits, and standards can ensure alignment with the company's risk tolerance and improve the overall creditworthiness of the receivables portfolio. For example, shortening payment terms from Net 60 to Net 30 days can accelerate cash flow. Tightening credit standards and lowering limits for high-risk customers also reduces bad debt exposure.
Implement Early Payment Incentives
Offering discounts for early or on-time payment incentivizes faster payment from creditworthy customers. For instance, a 2% discount for payment within 10 days can be an effective motivator. The cost of the discount should be weighed against the benefit of faster payment and reduced collection costs.
Enhance Billing & Collection Procedures
Streamlining invoice generation and implementing structured payment reminder processes (dunning) reduces receivable days outstanding. Automating parts of this collection process ensures consistency and timeliness. Clear communication of payment terms and due dates on each invoice is also essential.
Leverage Financial Modeling for Decision Making
Financial models help assess the potential impact of credit and collection changes on cash flow and bad debt expenses. Models can also determine optimal early payment discounts and appropriate credit limits by customer segment. Continually enhancing policies based on updated data improves accounts receivable turnover over time.
Concluding Remarks on Turnover Ratios
Monitoring accounts receivable turnover ratios provides valuable insights into a company's working capital and cash flow. By tracking metrics like DSO and days sales outstanding, businesses can benchmark performance over time and against industry standards.
Key Takeaways on Accounts Receivable Turnover
- The accounts receivable turnover ratio calculates how many times a business collects its average accounts receivable balance during a period. Higher ratios indicate more efficient credit and collection policies.
- Average DSO ratios vary widely by industry. Comparing your DSO to benchmarks helps assess operational efficiency.
- Improving turnover requires examining credit policies, collection procedures, and invoice processes to accelerate cash inflows.
Next Steps for Readers
Readers should:
- Calculate their accounts receivable turnover ratio and DSO using financial statements.
- Compare ratios to industry benchmarks to gauge operational performance.
- Identify areas to enhance credit, collections, and invoicing to improve turnover.
Monitoring accounts receivable turnover equips organizations to enhance working capital, cash flow, and credit management over time.
