Accounts Receivable Turnover Ratio

What is Accounts Receivable Turnover Ratio?

Accounts receivable turnover is the number of times per year that a business collects its average accounts receivable. The ratio is used to evaluate the ability of a company to efficiently issue credit to its customers and collect funds from them in a timely manner.

A high turnover ratio indicates a combination of a conservative credit policy and an aggressive collections department, as well as a number of high-quality customers. A low turnover ratio represents an opportunity to collect excessively old accounts receivable that are unnecessarily tying up working capital. Low receivable turnover may be caused by a loose or nonexistent credit policy, an inadequate collections function, and/or a large proportion of customers having financial difficulties. It is also quite likely that a low turnover level indicates an excessive amount of bad debt. It is useful to track accounts receivable turnover on a trend line in order to see if turnover is slowing down; if so, an increase in funding for the collections staff may be required, or at least a review of why turnover is worsening.

Key takeaways:

  • The accounts receivable turnover ratio is an accounting measure used to quantify a company’s effectiveness in collecting its receivables or money owed by clients.
  • A high receivables turnover ratio can indicate that a company’s collection of accounts receivable is efficient and that the company has a high proportion of quality customers that pay their debts quickly.
  • A low receivables turnover ratio might be due to a company having a poor collection process, bad credit policies, or customers that are not financially viable or creditworthy.
  • A company’s receivables turnover ratio should be monitored and tracked to determine if a trend or pattern is developing over time.

Accounts Receivable Turnover Ratio Formula

To calculate accounts receivables turnover ratio, add together beginning and ending accounts receivable to arrive at the average accounts receivable for the measurement period, and divide into the net credit sales for the year. The formula is as follows:

Net Annual Credit Sales ÷ ((Beginning Accounts Receivable + Ending Accounts Receivable) / 2)

Step 1: Determine your net credit sales.

The first part of the accounts receivable turnover formula calls for your net credit sales, or in other words, all of your sales for the year that were made on credit (as opposed to cash). This figure should include your total credit sales, minus any returns or allowances. You should be able to find your net credit sales number on your annual income statement or on your balance sheet.

Step 2: Determine your average accounts receivable.

Once you have your net credit sales, the second part of the accounts receivable turnover formula requires your average accounts receivable. Accounts receivable refers to the money that’s owed to you by customers. In order to find your average accounts receivable, then, you’ll take the number of your accounts receivable at the beginning of the year, add it with the value of your accounts receivable at the end of the year, and divide by two to find the average. You should be able to find the necessary accounts receivable numbers on your balance sheet.

Step 3: Divide.

Once you have these two values, you’ll be able to use the accounts receivable turnover formula. You’ll divide your net credit sales by your average accounts receivable to calculate your accounts receivable turnover ratio, or rate.

As a reminder, this ratio helps you look at the effectiveness of your credit, as your net credit sales value does not include cash since cash doesn’t create receivables. Therefore, if you have a lower number of payment collections from your customers, you’ll have a lower accounts receivable turnover ratio, and vice versa — if you have a higher number of payment collections from customers, you’ll have a higher ratio.

Example

For example, the controller of ABC Company wants to determine the company’s accounts receivable turnover for the past year. In the beginning of this period, the beginning accounts receivable balance was $316,000, and the ending balance was $384,000. Net credit sales for the last 12 months were $3,500,000. Based on this information, the controller calculates the accounts receivable turnover as:

$3,500,000 Net credit sales ÷ (($316,000 Beginning receivables + $384,000 Ending receivables) / 2)
= $3,500,000 Net credit sales ÷ $350,000 Average accounts receivable
= 10.0 Accounts receivable turnover

Thus, ABC’s accounts receivable turned over 10 times during the past year, which means that the average account receivable was collected in 36.5 days.

Analysis

Since the receivables turnover ratio measures a business’ ability to efficiently collect its receivables, it only makes sense that a higher ratio would be more favorable. Higher ratios mean that companies are collecting their receivables more frequently throughout the year. For instance, a ratio of 2 means that the company collected its average receivables twice during the year. In other words, this company is collecting is money from customers every six months.

Higher efficiency is favorable from a cash flow standpoint as well. If a company can collect cash from customers sooner, it will be able to use that cash to pay bills and other obligations sooner.

Accounts receivable turnover also is and indication of the quality of credit sales and receivables. A company with a higher ratio shows that credit sales are more likely to be collected than a company with a lower ratio. Since accounts receivable are often posted as collateral for loans, quality of receivables is important.

Interpretation of Accounts Receivable Turnover Ratio

The accounts receivable turnover ratio is an efficiency ratio and is an indicator of a company’s financial and operational performance. A high ratio is desirable, as it indicates that the company’s collection of accounts receivable is efficient. A high accounts receivable turnover also indicates that the company enjoys a high-quality customer base that is able to pay their debts quickly. Also, a high ratio can also suggest that the company follows a conservative credit policy such as net-20-days or even a net-10-days policy.

On the other hand, a low accounts receivable turnover ratio suggests that the company’s collection process is poor. This can be due to the company extending credit terms to non-creditworthy customers who experience financial difficulties.

Additionally, a low ratio can indicate that the company is extending its credit policy for too long. This can sometimes be seen in earnings management where managers offer a very long credit policy to generate additional sales. Due to the time value of money principle, the longer a company takes to collect on its credit sales, the more money a company effectively loses, or the less valuable the company’s sales. Therefore, a low or declining accounts receivable turnover ratio is considered detrimental to a company.

It’s useful to compare a company’s ratio to that of its competitors or similar companies within its industry. Looking at a company’s ratio relative to that of similar firms will provide a more meaningful analysis of the company’s performance than just an abstract calculation. For example, a company with a ratio of four, not inherently a “high” number, will appear to be performing considerably better if the average ratio for its industry is two.

Short summary:

  • Usually, the higher turnover ratio is preferred as it indicates the company’s efficiency to collect its receivables.
  • A higher ratio means that the company is collecting cash more frequently and/or has a good quality of debtors. This in turn means the company has a better cash position, indicating that it can pay off its bills and other obligations sooner. Many times, the accounts receivable turnover are posted as collateral for loans, making a good turnover ratio essential.
  • At the same time, a high turnover ratio may also mean that the company transacts mainly in cash or has a strict credit policy.
  • A lower ratio may mean that either the company is less efficient in collecting the creditor has a lenient credit policy or has a poor quality of debtors.
  • Looking at just the number (turnover ratio), doesn’t give the complete picture. It is better to check for the turnover ratio trends over the years to assess the true collecting efficiency of the companies. Many prudent analysts analyze if the company’s ratio is affecting its earnings. It is also useful to compare the turnover ratios of two companies in the same industry.

Tracking Receivables Turnover Ratio

A company’s receivables turnover ratio should be monitored and tracked to determine if a trend or pattern is developing over time. Also, companies can track and correlate the collection of receivables to earnings to measure the impact the company’s credit practices have on profitability.

For investors, it’s important to compare the accounts receivable turnover of multiple companies within the same industry to get a sense of what’s the normal or average turnover ratio for that sector. If one company has a much higher receivables turnover ratio than the other, it may prove to be a safer investment.

Receivables vs Asset Turnover Ratio

The asset turnover ratio measures the value of a company’s sales or revenues relative to the value of its assets. The asset turnover ratio is an indicator of the efficiency with which a company is using its assets to generate revenue. The higher the asset turnover ratio, the more efficient a company. Conversely, if a company has a low asset turnover ratio, it indicates it’s not efficiently using its assets to generate sales.

The accounts receivable turnover ratio measures a company’s effectiveness in collecting its receivables or money owed by clients. The ratio shows how well a company uses and manages the credit it extends to customers and how quickly that short-term debt is collected or being paid.

Receivables Turnover Ratio Limitations

Like any metric attempting to gauge the efficiency of a business, the receivables turnover ratio comes with a set of limitations that are important for any investor to consider before using it.

A limitation to consider is that some companies use total sales instead of net sales when calculating their turnover ratio, which inflates the results. While this is not always necessarily meant to be deliberately misleading, investors should try to ascertain how a company calculates its ratio or calculate the ratio independently.

Another limitation to the turnover ratio is that accounts receivables can vary dramatically throughout the year. For example, companies that are seasonal will likely have periods with high receivables along with perhaps a low turnover ratio and periods when the receivables are fewer and can be more easily managed and collected.

In other words, if an investor chooses a starting and ending point for calculating the receivables turnover ratio arbitrarily, the ratio may not reflect the company’s effectiveness of issuing and collecting credit. As such, the beginning and ending values selected when calculating the average accounts receivable should be carefully chosen so to accurately reflect the company’s performance. Investors could take an average of accounts receivable from each month during a 12-month period to help smooth out any seasonal gaps.

Any comparisons of the turnover ratio should be made with companies that are in the same industry, and ideally, have similar business models. Companies of different sizes may often have very different capital structures, which can greatly influence turnover calculations, and the same is often true of companies in different industries.

Lastly, a low receivables turnover might not necessarily indicate that the company’s issuing of credit and collecting of debt is lacking. For example, if the company’s distribution division is operating poorly, it might be failing to deliver the correct goods to customers in a timely manner. As a result, customers might delay paying their receivable, which would decrease the company’s receivables turnover ratio.

Leave a Reply

Your email address will not be published.