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What’s it: Accounts receivable turnover is a financial ratio showing the number of times a business converts accounts receivable into cash. Since accounts receivable represent a potential source of cash inflows for the company, a low ratio can lead to cash flow problems. Conversely, a higher accounts receivable turnover ratio means the company collects payments from customers more quickly. Thus, the company is trying to increase the receivables turnover ratio to increase revenue.
As with other financial ratios, the ideal accounts receivable turnover rate may vary between businesses in different industries. Therefore, it is important to compare the figures with other companies in the same industry to provide objective insight.
What is the accounts receivable turnover ratio measured?
Accounts receivable turnover ratio is a financial ratio to help measure the company’s financial health. It measures the number of times it collects accounts receivable on average during the accounting period. It gives us an understanding of how well the company manages the credit they give their customers and how quickly it collects money from customers. When the company is efficient and effective in collecting payments from customers, it will have a higher receivables turnover ratio.
Why do the accounts receivable turnover ratio matter?
Accounts receivable turnover ratio is a metric for comparing total sales revenue with actual customer payments. We can convert it to days of sales outstanding to show how many days on average a company collects payments for recorded sales during the accounting period.
Management and financial analysts scrutinize it carefully as it affects liquidity. Accounts receivable arise when the customer has received the goods but has not paid when the accounting report is prepared. So, the company receives cash payments not on the day the goods are delivered but several days after.
In preparing financial statements, companies report accounts receivable on the balance sheet and revenue on the income statement before receiving cash payments. Thus, although the revenue figures in the income statement increased during this period, but not with the company’s cash. Then, after receiving payment, the company reports an increase in cash and a decrease in accounts receivable at the same amount.
Problems can arise because not all customers pay bills on time. As a result, companies must collect them, which requires an effective credit and collection policy.
High-quality customers quickly pay for invoices sent to them. On the other hand, others may not pay their bills for weeks or even months after invoicing, which can lead to bad debts and less likely the company will be able to collect money from customers.
By monitoring the inventory turnover ratio over time, management can predict how much working capital they have and how much money they collect. In addition, checking and evaluating it helps protect the company from cash flow problems due to having to pay some short-term obligations.
How to calculate and read the accounts receivable turnover ratio? What’s the formula?
We calculate the accounts receivable turnover ratio by dividing sales on credit by the average accounts receivable turnover. Accounts receivable is on the balance sheet in the current assets section. We calculate the average accounts receivable balance by adding the beginning accounts receivable balance to the ending accounts receivable balance and then dividing the amount by two.
Meanwhile, as an alternative to selling on credit, we can also use the sales figures contained in the income statement. The following is the formula for the accounts receivable turnover ratio:
- Accounts receivable turnover = Sales on credit / Average accounts receivable
Take, for example, a simple calculation. A company posted sales of $4 million. Meanwhile, the average accounts receivable on its balance sheet is $400,000.
Inputting this data into the formula above, we get an accounts receivable turnover ratio of 10 = $4,000,000 / $400,000.
How to read the accounts receivable turnover ratio?
A higher accounts receivable turnover ratio is better because the company can raise money more quickly. It may be because customers pay bills promptly due to its effective credit and billing policies.
Conversely, a lower ratio is undesirable because it takes longer to collect payments. It can disrupt liquidity and cash flow within the company. The cause may be ineffective in the company’s credit policies or billing procedures. Or the company is too lax in providing credit.
Special note
We must carefully deduce the above ratios. For example, despite being favored, a high ratio can also come with other consequences. It could be due to credit or collection policies that are too strict, which can hurt sales if competitors offer customers more lenient credit terms. It could jeopardize good long-term relationships with customers and cause some customers to turn to competitors.
Does the high ratio come from effective credit and collection policies or not? We can compare the company’s sales growth with industry growth. It helps us to find the reason behind the high turnover rate.
Then, we can also compare the current estimated bad debts with their values in the previous period and peer companies. Finally, it aims to explore whether low receivables turnover results from credit management problems or not.
