Effective accounts receivable management is crucial when it comes to maintaining healthy cash flow, building operational resilience, and fueling growth. By managing accounts receivable more effectively, you can enhance its performance. This offers a range of benefits, including the ability to put the money you’re owed to use more quickly.
Before you think about improving accounts receivable performance, you need a clear understanding of its current state. That makes it necessary to adopt key performance indicators (KPIs) or metrics designed specifically to measure accounts receivable performance. Accounts receivable turnover ratio is a particularly suitable metric in this respect.
The accounts receivable turnover ratio (also known as the receivables turnover ratio) is an accounting metric that quantifies how efficiently a company collects its receivables from customers or clients. Measuring the number of times that accounts receivables are turned into cash during a given period, the ratio is essentially a lens through which a company can gauge the effectiveness of its accounts receivable process. The higher the turnover ratio, the more efficient the process.
Accounts receivable turnover ratio is similar to another commonly used metric: days sales outstanding. Whereas DSO is calculated by dividing a business’s accounts receivable by its sales, the receivables turnover ratio is calculated by dividing a business’s total credit sales by its average accounts receivable. Another difference between the two metrics is that DSO is expressed in days rather than as a ratio.
The accounts receivable turnover ratio expresses the time taken to collect outstanding debt throughout the accounting period. The formula for working it out is as follows:
You can calculate the accounts receivable turnover ratio by following these steps:
During the period from January 1 to December 31, Company X had gross credit sales of $2.3 million. With sales discounts of $100,000, sales returns of $125,000, and sales allowances of $75,000, its net credit sales were $2 million.
$2,300,000 – $100,000 – $125,000 – $75,000 = $2,000,000
The company had an opening accounts receivable balance of $420,000 and a closing balance of $380,000, giving an average accounts receivable of $400,000.
$420,000 + $380,000 / 2 = $400,000
So, with net credit sales of $2,000,000 and average accounts receivable of $400,000, Company X’s receivables turnover ratio was 5.0.
$2,000,000 / $400,000 = 5.0
In other words, Company X collected its average accounts receivables five times during the one-year period.
A high accounts receivable turnover indicates that customers pay their invoices relatively quickly. This could be due to having a reliable customer base or the business’s efficient accounts receivable process.
However, it’s important to note that the receivables turnover ratio may be artificially high if the business is overly reliant on cash sales or if it has a restrictive credit policy. This could lead to depressed sales as customers seek firms willing to offer more generous credit terms.
By contrast, a low receivables turnover ratio may indicate an inefficient collection process, bad credit policies, or an unreliable customer base. It can also be influenced by factors such as slow deliveries or poor quality, leading to delayed or disputed invoice payments.
Like any metric, the receivables turnover ratio has its limitations. For example, businesses with seasonal or cyclical sales models will see large fluctuations at different times, making the ratio less accurate in measuring overall credit effectiveness.
Whereas DSO measures the average number of days taken to collect on receivables, the receivables turnover ratio measures how many times a business’s receivables are turned over in a given period. It can be a good way to determine whether a company’s collections policy is trending faster or slower over time. Because of this, the receivables turnover ratio is best used as a comparative metric.
It can also be used to compare the efficiency of a business’s AR process to others of a similar size operating in the same industry, providing that they use the same metrics and inputs.
Companies may be able to drive improvements to the receivables turnover ratio by taking the following steps: