Accounts Receivable Turnover Ratio is a key metric for businesses. A good score is essential to attract investors if your business seeks credit. Even if growth funding is not a priority currently, this ratio is important to understand your business’ efficiency in collecting outstanding credits.
Accounts Receivable Turnover Ratio in Detail
Also referred to as Receivables Turnover, the Accounts Receivable Turnover Ratio specifies the count of credit collections per year by a business. If you have customer accounts with outstanding payments, the turnover ratio tells you how successful you have collected such payments.
Payment terms may be different for different businesses. For example, some businesses may require payment before the delivery of a service or product. Some businesses may require payment after a service or product delivery.
For example, Business A may offer a credit of 30 days starting a day after invoice generation for a product/ service delivered. Business B may necessitate bill payment 30 days before a service/ product is delivered.
Business B has better protection against payment defaults as it provides its product/ service only after bill fulfilment. On the other hand, Business A faces the risk of bad debts – some customers may pay late while some may shut down, making the outstanding credit a loss.
Regardless of the payment terms, this ratio reveals the predictability of cash flow into a business. It also helps you understand if improved strategies need to be implemented for better credit risk management.
How to Calculate Accounts Receivable Turnover Ratio
Businesses calculate the value of the Accounts Receivable Turnover Ratio by dividing the net sales from credit by the average value of accounts receivables. Businesses calculate these values over a given time.
To compute the accounts receivable ratio, first, you need to calculate the total of the accounts receivables at the beginning and the end of the given period. Then, divide this value by 2 to get the average accounts receivables for this specific period. Divide the net credit by this value to get the required ratio.
Step A: Obtain the average accounts receivables for the specific period.
Step B: Divide the net credit sales over the period by the above average.
Accounts Receivable Turnover Ratio = (Net Yearly Credit Sales) / (Average of Annual Accounts Receivables)
Accounts Receivable Turnover Ratio Example
As an example, Business A records accounts receivables of $1, 000, 000 at the start of a year. At the end of the year, its accounts receivables are $1, 500, 000. The company records net credit sales of $10 million over the year.
The Accounts Receivables Turnover Ratio for the company:
Average accounts receivables = ($1, 000, 000 + $1, 500, 000)/ 2 = ($2, 500, 000)/ 2 = $1, 250, 000
Accounts Receivables Turnover Ratio = $ 10, 000, 000/ $1, 250, 000= 8
Business A collected its credit accounts 8 times in that specific year.
Significance of Accounts Receivable Turnover Ratio
This Accounts Receivables Turnover Ratio indicates your business’s ability to collect its credit. The higher the ratio, the more efficient your company is at credit collections.
Your analysts understand how quickly and efficiently your business can collect outstanding payments based on the ratio. It’s important data that can help you make better decisions in improving your processes or upgrading your accounts receivable automation software. This ratio gives your analysts a clear picture of your business’s financial stability and is vital for planning business growth.
The turnover ratio also informs if you have to review your credit policies. A poor ratio could signify that you need to analyze and reframe your payment terms and credit application policies to invite more cash flow into the business.
Continuous monitoring of your Accounts Receivable Turnover Ratio tells how financially good your business is. Ensure that this efficiency ratio stays high so that your business prospects of growth are good.