Definition: The accounts receivable turnover ratio is an efficiency ratio that measures how often receivables are collected during a period. It also calculates both the quality and liquidity of the customer account balances. In other words, A/R turnover shows how many times a company can collect its average total accounts receivable during an accounting period.
What Does Accounts Receivable Turnover Mean?
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What is the definition of accounts receivable turnover?
The accounts receivable turnover ratio is more than just a financial metric; it is a vital indicator of a company’s ability to manage credit sales and collect payments efficiently. A high turnover ratio reflects effective credit policies and strong cash flow, while a low ratio may signal collection challenges or risks associated with extending credit to customers.
This ratio helps measure two main things. First, it shows how efficiently and effectively a company can sell on credit and collect from customers. Obviously credit sales don’t do a company a lot of good if it can’t collect the actual cash from the customers when payments are due. Receivables turnover shows how often and how easily the company can collect money from its customers’ credit sales.
Second, it implicitly shows the quality of the customers that the company allows to purchase on credit. A company with a low accounts receivable turnover ratio could indicate that the company is having a difficult time trying to collect the money from the customers. If the company is allowing non-creditworthy customers to purchase goods on credit, the true value of the accounts receivable on the balance sheet is misleading because this amount will never be fully collected. Customers will default and the company will have to write off some of its receivables.
Investors and creditors use this ratio to help identify the liquidity and true value of the total receivables. In other words, they want to estimate how much will actually be collected and when the collections will take place.
The accounts receivable turnover formula is calculated by dividing net sales for the period by average accounts receivable. Since most of the time businesses don’t calculate a running average receivables total, we tend to use the average for the period by adding the beginning and ending balances and dividing by two.
The Importance of Accounts Receivable Turnover
Accounts receivable turnover measures how efficiently a company collects payments from its credit customers. By indicating the speed at which receivables are converted into cash, this ratio offers insights into a company’s liquidity and operational efficiency.
For instance, a wholesale distributor with a high turnover ratio demonstrates strong credit management and a steady inflow of cash, which can be reinvested into the business. Conversely, a low ratio may suggest issues such as lax credit policies, poor collection practices, or an over reliance on non-creditworthy customers.
Calculating the Accounts Receivable Turnover Ratio
The formula for calculating accounts receivable turnover is:
Accounts Receivable Turnover Ratio = Net Credit Sales / Average Accounts Receivable
- Net Credit Sales: Total revenue from credit sales during the period, excluding cash sales and returns.
- Average Accounts Receivable: Calculated as the sum of beginning and ending accounts receivable balances, divided by two.
For example, a company with $1,000,000 in net credit sales and an average accounts receivable balance of $200,000 would have an A/R turnover ratio of:
1,000,000 / 200,000 = 5
This means the company collects its receivables five times during the year.
Practical Example
Consider a furniture manufacturer that sells to retailers on credit terms. Over the year, it generates $3,000,000 in credit sales and has an average accounts receivable balance of $500,000.
Using the formula:
A/R Turnover Ratio=3,000,000500,000=6\text{A/R Turnover Ratio} = \frac{3,000,000}{500,000} = 6A/R Turnover Ratio=500,0003,000,000=6
This indicates the company collects its receivables six times per year, or approximately every 60 days. If the industry average is 45 days, the company may need to revisit its credit policies or collection strategies to improve efficiency.
Factors Influencing the A/R Turnover Ratio
Several factors can affect the accounts receivable turnover ratio, including:
Credit Policies
Flexible terms may attract more customers but can increase the risk of delayed payments.
Customer Quality
Extending credit to reliable customers ensures timely collections, improving the ratio.
Industry Practices
Some industries, such as construction, have inherently longer credit cycles.
Collection Processes
Efficient invoicing and follow-ups accelerate payments and boost the ratio.
For example, a tech company offering net-30 terms and using automated payment reminders may experience a higher turnover ratio than a competitor with manual invoicing and extended payment terms.
Interpreting the Accounts Receivable Turnover Ratio
A higher turnover ratio generally indicates:
- Efficient Collections: The company is effective at converting receivables into cash.
- Reliable Customers: Credit is extended to customers with strong payment histories.
- Healthy Liquidity: The company maintains a steady cash flow to support operations.
On the other hand, a lower ratio may suggest:
- Inefficient Collections: Delays in collecting payments from customers.
- Risky Credit Practices: Overextending credit to less reliable customers.
- Cash Flow Challenges: Struggles to convert receivables into working capital.
Accounts Receivable Turnover vs. Days Sales Outstanding (DSO)
While the A/R turnover ratio measures the frequency of collections, Days Sales Outstanding (DSO) calculates the average number of days it takes to collect receivables. The formulas are interconnected:
DSO=365 / A/R Turnover Ratio
For example, a company with an A/R turnover ratio of 6 has a DSO of:
365 / 61 days = 6
This metric complements the turnover ratio by providing a time-based perspective on collections.
Strategies to Improve Accounts Receivable Turnover
Businesses can enhance their A/R turnover ratio through:
Tightening Credit Policies: Perform credit checks and set appropriate limits for new customers.
Streamlining Collections: Automate invoicing and payment reminders to reduce delays.
Offering Discounts: Incentivize early payments with discounts for settling invoices before due dates.
Monitoring Aging Reports: Regularly review overdue accounts and follow up promptly.
For instance, a manufacturing firm offering a 2% discount for payments within 10 days may accelerate collections, boosting its turnover ratio.
Limitations of the Accounts Receivable Turnover Ratio
While the A/R turnover ratio is a valuable indicator, it has limitations:
Exclusion of Cash Sales: The ratio focuses solely on credit sales, which may not reflect the company’s overall sales efficiency.
Industry Variances: Different industries have varying credit cycles, making cross-industry comparisons less meaningful.
Average Balances: Using average accounts receivable may mask fluctuations in individual periods.
Summary Definition
Define Accounts Receivable Turnover: Receivables turnover means the amount of times a company collects its entire receivables account over the course of a year.
Frequently Asked Questions
What is accounts receivable turnover?
Accounts receivable turnover is a financial metric that measures how many times a company collects its average accounts receivable during a specific period. It reflects the efficiency of a company’s credit and collection processes.
How is accounts receivable turnover calculated?
The accounts receivable turnover ratio is calculated by dividing net credit sales by the average accounts receivable for the period. This shows how effectively a company collects payments from its credit customers.
What does a high accounts receivable turnover ratio indicate?
A high accounts receivable turnover ratio indicates efficient collections and strong credit management. It suggests the company is converting receivables into cash quickly and minimizing overdue accounts.
What are common reasons for a low accounts receivable turnover ratio?
A low accounts receivable turnover ratio may result from inefficient collection processes, lenient credit policies, or unreliable customers. It could signal cash flow issues and the need for stricter credit and follow-up practices.
Bottom Line
The accounts receivable turnover ratio is a key metric for assessing a company’s credit management and cash flow efficiency. By understanding its implications, businesses can identify areas for improvement, optimize their credit policies, and ensure healthy liquidity.
While the ratio provides valuable insights, it should be analyzed alongside other metrics, such as DSO and aging reports, for a comprehensive view of a company’s financial health. In an increasingly competitive market, businesses that effectively manage their accounts receivable can gain a significant advantage, ensuring sustained growth and stability.
