Businesses have assorted methods of receiving credit card payment from their customers. Most accept a various mix of cash, checks, Best business debit cards, and credit carformds. Some business customers use established lines of credit with negotiated terms, such as payment due dates or rates.

Payment methods that deal in credit are classified under accounts receivable. As you operate your business and track your financial information, you generate data on your accounts receivable. You’ll have information such as the amount of time it takes each one of your customers to pay.

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You have to calculate and evaluate the average number of days it takes to sell your goods or services on credit and then collect payment. The consequence of this calculation is the Accounts Receivable Turnover Ratio.

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What Is Receivable Turnover Ratio?

Accounts Receivable Turnover - How To Calculate Accounts Receivable Turnover Ratio

The accounts receivable turnover ratio is one of the important business finance accounting formulas to quantify and demonstrate a company’s effectiveness in collecting its receivables or money owed by clients or customers.

The ratio displays how well a company uses and manages the credit it extends to customers and how quickly that short-term debt is collected or is paid. The receivables turnover ratio is the accounts receivable turnover ratio.

Formula For Calculating Accounts Receivable Turnover Ratio

You will need to reference your business’ balance sheet and income statement for the information. The accounts receivable turnover ratio is calculated with the help of the following formula you can see below here.

Net Annual Credit Sales ÷ ((Total Accounts Receivable) ÷ 2)

Net Annual Credit Sales is the total value of sales for the year on credit, subtracting any returns, allowances, and discounts. Total accounts receivable is the sum or total of your beginning accounts receivable and your ending accounts receivable, divided by 2.

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Here are the steps

  • Add and include the value of accounts receivable at the beginning of the desired period to the value at the end of the period and divide the sum by two. The result is the denominator in the formula.
  • Divide the value of net credit sales for the period by the average accounts receivable during the same period.
  • Net credit sales are the revenue generated from sales that were done on credit minus any returns from customers.

The result and answer of the calculation is the number of times that your business’ accounts receivable turned over in the past year. While you can keep the number as is, it is easier to understand if it is in days.

For example, if you had an average accounts receivable turnover (the result of the equation) of 20, it means your average collection time is 18.25 days (365 ÷ 20). This means it takes 18 days on average to collect on your receivables.

Receivables Turnover Ratio Inferences

Companies that maintain accounts receivables are indirectly extending interest-free small business loans to their clients since accounts receivable is money owed without interest. If a company generates a sale to a client, it could extend terms of 30 or 60 days, meaning the client has 30 to 60 days to pay for the product.

The receivables turnover ratio measures and calculates the efficiency with which a company collects on their receivables or the credit it had extended to its customers.

The ratio also measures how many times a company’s receivables convert into cash in a period. The receivables turnover ratio calculate on an annual, quarterly, or monthly basis.

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High Accounts Receivable

A high receivables turnover ratio can indicate and demonstrate 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 high receivables turnover ratio might also indicate that a company operates on a cash basis.

It can also suggest that a company is conservative when it comes to extending credit to its customers. Conservative credit policy can be beneficial since it could help the company avoid extending credit to customers who may not be able to pay on time.

On the other hand, if a company’s credit policy is too conservative, it might drive away potential customers to the competition who will extend them credit.

If a company is losing clients or suffering slow growth, they might be better off loosening their credit policy to improve sales, even though it might lead to a lower accounts receivable turnover ratio.

Low Accounts Receivable

A low receivables turnover ratio can be because of the company having a poor collection process, bad credit policies, or customers that are not financially viable or creditworthy.

Typically, a low turnover ratio implies that the company should reassess its credit policies to ensure the timely collection of its receivables. However, if a company with a low ratio improves its collection process, it might lead to an influx of cash from collecting on old credit or receivables.

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Tracking Receivables Turnover Ratio

A company’s receivables turnover ratio must be monitored, tracked and overseen 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 is 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 and calculates 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.

Limitations of Receivables Turnover Ratio

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 of 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 when calculating the average accounts receivable should be carefully chosen so as 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 various sizes can often have very different and unique 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 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 postpone or hold up paying their receivable, which would decrease the company’s receivables turnover ratio.

Key Points About Receivable Turnover Ratio

  • The accounts receivable turnover ratio is an accounting measure to quantify a company’s effectiveness in collecting its receivables or money owed by clients.
  • A high receivables turnover ratio can demonstrate 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 and bad collection process, bad credit policies, or customers that are not financially viable or creditworthy.
  • A company’s receivables turnover ratio must be checked and tracked to determine if a trend or pattern is developing overtime or not.
  • High average collection times can be an indicator of collection policies in need or requirement of adjustment. However, this is not always the case. Your customers may not be receiving goods or services as promised, causing returns or refusals to pay.
  • A collection period with a high number of days is an indication that you may need to investigate something. Alternately, it could mean that the nature of your business results in slower collection times.
  • Low average accounts receivable collection times may be a signal that your collection policies are working. It might mean that your policies are too restrictive for buyers with less than impeccable credit. If this is the case, you could be losing customers to competitors with less restrictive collection policies.
  • You can also make use of your accounts receivable turnover ratio to compare your business with other companies in your industry. When comparing ratios, it is important to keep in mind that no two businesses operate exactly alike. Find and look for businesses that are as similar to yours as possible for comparison.

Benefits of Using Accounts Receivable Turnover Ratio

While the accounts receivable turnover ratio provides insight into the collection management of a company, it is best used as an informational tool. It doesn’t point to a problem with your collections staff or policies for good.

Use the ratio to identify any customer problems. A comparison of your accounts receivable can give you an indication of trends in collections. Identifying continuous late payments can keep a customer in financial trouble from using credit extended to them, by you, for purchases.

Furthermore, identifying customer payment trends, the most valuable use of the accounts receivable turnover ratio is having a tool to measure your own collection methods, address any issues, and look for the most efficient and essential collection period for your business.

Conclusion

A company could improve its turnover ratio by making and including some useful alterations to its collection process. A company could also offer its customers discounts for paying early. It’s important for companies to know their receivables turnover since its directly tied to how much cash they’ll available to pay their short term liabilities.

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