Accounts receivable is any money your customers owe you for goods or services they purchased from you in the past. This money is typically collected after a few weeks, and is recorded as an asset on your company’s balance sheet. You use accounts receivable as part of accrual basis accounting. You can find accounts receivable under the ‘current assets’ section on your balance sheet or chart of accounts. Accounts receivable are classified as an asset because they provide value to your company. (In this case, in the form of a future cash payment.)
The accounts receivable turnover ratio is a quick and easy indicator of how efficiently a business collects revenue from credit sales. It is also called the receivables turnover ratio, the accounts receivable turnover, or the debtors turnover ratio.
An accountant officer will calculate the accounts receivable turnover ratio periodically. They run the AR formula to determine how quickly a business turns over its receivables (money owed by clients) into cash. This is the business’ collection time. A good AR turnover ratio suggests the business is getting paid fast.
- The accounts receivable turnover ratio as one measure of a business’ speed to collect the money owed to it by customers.
- A business should aim to have a high AR turnover in relation to its industry and past performance. However, a high receivables ratio can also mask a downturn in sales.
- A company can improve its receivables turnover ratio by optimising its collections policy and procedures. This means that accounts receivable staff and customers follow a prompt payment protocol.
- A decreasing accounts receivable turnover ratio indicates that a business is recovering cash slower than previously.
The receivables turnover formula
Accounts Receivable Turnover Ratio = Annual Credit Sales / Accounts Receivable
- Start with the amount of credit sales for the year.
- Divide credit sales by the average balance in accounts receivable for the same year.
For example, if Company ABC makes $1,000,000 credit sales in a year, and has a balance of $125,000 in accounts receivable at the end of that year, its accounts receivable turnover ratio is 8. (1,000,000 / 125,000).
This means that Company ABC turns over its accounts receivable eight times per year, on average. Using the 365-day accounting year, Company ABC’s average collection time on credit sales is 45.6 days (365 / 8).
What’s more, this calculation of average collection time also arrives at the more commonly termed Days Sales Outstanding (DSO) which typically uses the 365-day calendar year.
Days Sales Outstanding = (Accounts Receivable / Net Credit Sales) x 365
While DSO is usually calculated at year-end (using 365 days), DSO can also be calculated using balances at different periods e.g. 30 days.
What’s a ‘good’ or ‘bad’ accounts receivable turnover?
A higher ratio number indicates that collections happen faster. For example, if a business increases its turnover ratio from 4 to 8, it is collecting its cash twice as fast.
However, on its own, the turnover ratio won’t provide a complete picture. In fact, a short term view will paint an incomplete picture.
With that in mind, the best way to determine if a business’ AR turnover ratio is ‘good’ or ‘bad’ is to look at the long term trends and consider the ratios within a wider context.
Understanding your receivables turnover ratio
Use other data to interpret the AR turnover ratio:
- Historical accounts receivable turnover ratios in the same business. (A current ratio lower than previous periods means collections are taking longer.)
- Industry standard receivable turnover ratios. (Some industries are routinely slower to pay than others.)
- Your specified credit terms. (If your AR ratio indicates payments are extending well beyond terms, there’s room for improvement.)
- Number of credit customers. (Fewer customers than the previous year may make collections quicker, but fewer customers is generally not the goal of business.)
- Value of credit customers. (The receivables turnover ratio can be skewed if there are one or two exceptionally large customers with balances owing.)
- Annual sales. (Quicker collection processes might improve the ratio, masking a decrease in sales.)
- General economic conditions. (If interest rates are higher than the previous year, businesses might expect a lower ratio as customers hold onto their cash for longer.)
How to improve the accounts receivable turnover ratio
Increasing the debtors turnover ratio year after year indicates a business is improving its collection time. Cash recovery is accelerated, and that means there’s more money available as working capital. That’s a great goal to achieve, but not at the expense of reduced annual sales or customers, so an ‘improved’ or ‘high’ turnover ratio should be interpreted in the context of overall growth.
A few tips to collect credit sales quickly:
1. Review credit policies. Make sure you are extending credit terms to customers based on their likelihood to pay on time. You can understand late payment risks with a credit risk analysis and credit monitoring service.
2. Ensure sales and finance teams are enforcing agreed credit limits for each customer.
3. Actively follow-up the debtors that owe you the most money and are the most overdue. (The probability of getting paid reduces the longer an account ages.)
4. Get a Pay Now button onto your invoices and statements. When you streamline the online payments process for your customers, you get paid faster.
5. Issue invoices to customers promptly so that they have the opportunity to pay on time.
6. Automate your collection process as much as possible. Automate payment reminders so every customer hears from you when their payment is due soon and as they become overdue. Reminders are effective but time-intensive if your staff have to manually prepare and email them.
7. Investigate spikes—look for customer-specific issues. By being proactive you can stop a problematic credit customer from becoming a bad debt write-off in the future.
8. Be prepared to engage third party debt collection or legal services.
9. Review customer satisfaction and address any disputes or issues impacting prompt payment.
A business can improve its accounts receivable turnover ratio by optimising its credit control and collection processes. Recovering cash quickly is a vital function to protect working capital. Track the receivables turnover ratio to assess a business’ collection efficiency over time.
Source – https://www.ezycollect.com.au/blog/2019/11/26/accounts-receivable-turnover-ratio-how-to-interpret-and-improve-it/