If you’re a manufacturer or supplier that regularly extends business credit, you know there’s a certain degree of risk involved. That’s why it’s so important to make sure you’re able to collect on debts as efficiently as possible. One of the most common ways that businesses do this is by calculating its accounts receivable turnover ratio.
In this article, we’ll cover the basics of this accounting formula, including what it is, why it’s important, how to calculate it, and how to analyze the data.
How to Calculate Your Accounts Receivable Turnover Ratio
To calculate your accounts receivable turnover ratio for a particular period, you’ll first need to determine your net credit sales and average accounts receivable. Then, divide net credit sales by the average accounts receivable, and you have your ratio.
Note that this formula uses net credit sales (not net sales). The reason for this is that non-credit sales don’t create receivables. So, cash sales do not apply in this equation.
Accounts Receivable Turnover Ratio Defined
The accounts receivable turnover ratio is a formula used in accounting to measure how efficiently a business is extending credit and collecting debt.
While it may sound complex, it’s actually quite easy to calculate because it only requires two budget numbers – net credit sales and average accounts receivable.
The accounts receivable turnover formula helps businesses keep a close eye on cash flow. In other words, it helps companies ensure that they don’t spend (or lend) more than they earn.
By implementing the accounts receivable turnover ratio, you can identify collections issues quickly and make necessary changes to improve cash flow before things get out of hand.
In addition, when a business carefully manages its cash flow, it can better meet critical expenses such as payroll, rent, and other overhead costs. If you fail to manage cash flow, you may find your business unable to access the funds needed to operate, resulting in growth stagnation or outright failure. These high stakes make cash flow management a major component of minimizing financial risk.
So now that you understand the significance of the accounts receivable turnover ratio, it’s time to learn how to calculate it.
Examples of Calculated Turnover Ratios
To help illustrate this formula in action, let’s look at the two examples below:
- Company “A” has $500,000 in net credit sales for the year, and its average accounts receivable equals $125,000. To calculate their accounts receivable turnover ratio, they divide net credit sales ($500,000) by the average accounts receivable ($125,000) and end up with the number four.
- Company “B” also has $500,000 in net credit sales for the year, but its average accounts receivable equals $50,000. When their net credit sales ($500,000) are divided by their average accounts receivable amount ($50,000), they get a ratio of 10.
So, which ratio is better, and what do the numbers mean for your business? Let’s dive in a little deeper to find out.
Analyzing the Data
Is there an ideal accounts receivable turnover ratio? The short answer is “yes,” but in order to understand what makes it a good ratio, let’s review why this number is so important.
Again, the accounts receivable turnover formula helps measure how efficiently your business extends credit and collects payments. The more efficient you are, the more easily you’re able to maintain a positive cash flow, which in turn, ensures that you have enough money to pay for operations and invest in growth opportunities. With that in mind, let’s compare Company A and Company B:
- Company A has a ratio of four, which means they’re “turning over” (collecting) receivables four times a year, or once every quarter.
- Company B’s ratio is 10, meaning that they’re collecting accounts receivable 10 times a year.
A higher turnover ratio, like Company B’s, indicates that they’re more likely to receive get paid and less likely to have to write off bad debt, which would be a risky scenario for any business.
Additionally, since Company B’s ratio is higher than Company A’s, we might assume that Company B has a stronger credit policy and is managing debt collections more efficiently than Company A is.
As this example shows, it’s more ideal for companies to aim for a high ratio. If your company has a low ratio, there are measures you can take, like implementing tighter business credit policies, to lessen the frequency of bad debt and help improve your ratio over time.
Know Your Limits
While the accounts receivables turnover ratio is a great tool for keeping tabs on how effectively your business is extending credit and collecting payments, it can only go so far, and it definitely has its limits.
For instance, calculating your turnover ratio simply helps you identify whether there’s an issue. It cannot tell you exactly what’s causing the issue.
There are a number of things that could be lowering your turnover ratio, such as known customer accounts that are notoriously past due, lax lending policies, overrides from sales, and more. Therefore, once you determine that you have a low ratio, it’s important to figure out what the root causes are.
Another thing to consider is that since the ratio is based on average accounts receivable, it can seem distorted by a select few customers who either pay extraordinarily quickly or frustratingly slowly. If that’s the case, your ratio might not accurately reflect your true efficiency.
Similarly, accounts receivables can fluctuate throughout the year, possibly throwing your ratio off balance even further. That’s why it’s important to also factor in aging accounts to paint a more accurate picture of your overall customer payment behavior.
And finally, if your customers come from different industries and sizes, you’ll want to make sure your accounts are segmented accordingly before calculating your accounts receivable turnover ratio, so you’re comparing apples to apples. This, too, will help ensure a much more accurate figure from which to analyze further.
Because the accounts receivable turnover ratio does have some limitations, you might want to consider using additional tools to help ensure your company is practicing accounts receivable management as effectively as possible. D&B Finance Analytics Receivables Intelligence is easy-to-use, easy-to-implement software that combines invoicing, collections, payments, and cash management into a powerful automation engine. If you'd like to learn more about D&B Finance Analytics, get your personalized demonstration today!