What is Accounts Receivable Turnover?
Accounts receivable turnover measures how efficiently a company deals with the credit it offers to customers and how regularly it collects on those accounts. It’s sometimes referred to as “debtors’ turnover.”
The accounts receivable turnover ratio is a numerical representation of a company’s willingness to offer credit and the expected time until it’s repaid. It represents the number of times credit accounts are turned over into cash during a given accounting period.
Business owners can calculate turnover and ratio and use it as a snapshot. They also can monitor results over time to identify an improvement or deterioration.
In order to understand this term, it’s vital to first have an understanding of what accounts receivable is. Accounts receivable is defined as the money owed to a business for goods supplied or services completed. These debts are legally enforceable and usually arise because of a business extending credit to one or more of its customers.
Uses of accounts receivable turnover
Accounts receivable turnover is the number of times that a business converts its accounts receivable into cash in a given accounting period. Different stakeholders use this accounting measure in a range of ways.
Companies use accounts receivable turnover as a means of tracking credit lines. Analysts use it to determine asset efficiency. Meanwhile, investors use it to analyze the financial risks involved with a given company. For example, a company with a higher accounts receivable turnover may be considered less of a financial risk than a company with a lower ratio. Accounts receivable turnover may also be used during mergers and acquisitions to identify cash flow bottlenecks.
How is it calculated?
The basic formula to work out accounts receivable turnover ratio is:
To determine the average accounts receivable value, add the starting accounts receivable turnover value to the accounts receivable at the end of the desired period, and then divide this amount by 2. This will give an average of the two figures, which represents the net credit sales. Note that the net credit sales figure excludes returns and allowances on sales. Finally, divide the value of net credit sales by the average accounts receivable during the same period.
How to interpret accounts receivable turnover
Typical accounts receivable values vary from industry to industry. They’re influenced by a range of factors, including the permissible credit period. A ratio of 10 means that the accounts receivables are turned over 10 times a year, or every 36.5 days. This is the average number of days between a credit sale being finalized and the customer making payment.
It’s generally accepted that a higher ratio is better than a lower one. A ratio of 10 means that credit accounts are paid off in 36.5 days, while a ratio of 5 means that a business waits an average of 73 days to receive that payment. In other words, a company waits longer to receive the money owed to it when the ratio is lower.
Low turnover ratio
A low turnover ratio may be caused by generous payment terms. It may also be the result of a poor-performing debt recovery or accounts team.
If a company wishes to increase its low turnover ratio, there are numerous ways to go about it, including:
- Tightening credit policies - Reducing credit terms from 60 to 30 days could significantly improve an accounts receivable ratio.
- Improving the invoicing system - If invoices take a long time to arrive with customers, and many of them are being returned with invoicing errors, this drives the ratio down. But it also represents an actionable improvement that can be made.
- Offering greater payment flexibility - Providing more payment options could help to increase a low accounts receivable ratio. For example, if a business only allows payment by direct transfer and not card or cash payments, it may cause delays with some customers.
High turnover ratio
While a high accounts receivable turnover is generally considered advantageous, if it’s too high, it could be indicative of overly stringent credit terms. This could deter some potential customers and prevent sales. Therefore, a very high ratio warrants further investigation.
The accounts receivable turnover ratio represents the number of times account receivables are turned over into cash during an accounting period. High ratios are generally considered more desirable than lower ones, but a ratio that is too high may not be optimal either.
For investors, a company with a high accounts receivable ratio may be seen as less of a risk than a company with a low one. It also could indicate that the business is on top of its invoicing and credit repayments.