Accounts receivable turnover ratio: How to interpret and improve it

by | Nov 26, 2019 | 0 comments

The accounts receivable turnover ratio is a quick and easy indicator of a business’ success in collecting revenue from credit sales. You’ll also see it referred to as the receivables turnover ratio, or the accounts receivable turnover. The accounts receivable turnover ratio equation is simple to calculate from the accrual accounts. It’s a good measure of future cashflow expectations from credit sales. Importantly, changes in the accounts receivable turnover ratio can point towards cashflow troubles, or on the upside, an improvement in collection times.

How to calculate the accounts receivable turnover ratio

The best thing about the accounts receivable turnover ratio is how easy it is to calculate! It’s an average figure determined by dividing a company’s annual credit sales by the average balance in accounts receivable in the same period. Here’s the accounts receivable turnover ratio equation:

Accounts receivable turnover ratio = Annual credit sales  /  Accounts receivable

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).

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).

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.

DSO = (Accounts receivable / Net credit sales) x 365

While DSO is commonly calculated at year-end (using 365 days), DSO can also be calculated using balances at different periods e.g. 30 days.

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What’s a ‘good’ or ‘bad’ accounts receivable turnover ratio?

The best way to determine if a business’ accounts receivable turnover ratio is ‘good’ or ‘bad’ is to interpret it within a wider context of financial data. Remember, the ratio is an average, taken at a specific (maybe one) point in the business cycle. On its own, the ratio won’t provide a complete picture and may mask some relevant highs and lows in the cycle or some long overdue accounts.

Use other data to interpret the accounts receivable turnover ratio:

  1. Historical accounts receivable turnover ratios in the same business (a lower ratio than previous periods means collections are taking longer).
  2. Industry standard receivable turnover ratios (some industries are routinely slower to pay than others).
  3. Your specified credit terms (if your accounts receivable turnover ratio indicates payments are extending well beyond terms, there’s room for improvement).
  4. Number of credit customers (fewer customers than the previous year may make collections quicker, but fewer customers is generally not the goal of business).
  5. Value of credit customers (the receivables turnover ratio can be skewed if there are one or two exceptionally large customers with balances owing).
  6. Annual sales (quicker collection processes might improve the ratio, masking a decrease in sales).
  7. 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).

Improving the accounts receivable turnover ratio

Increasing the accounts receivable turnover ratio year after year indicates a business is improving its collection times. 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’ ratio should be interpreted in the context of overall growth.

A few tips to keep the accounts receivable turnover ratio moving up:

  • Review credit policies to ensure credit terms and conditions are issued to customers based on sound due diligence that includes credit checks on new customers and credit monitoring to be alerted when customers become a high risk of defaulting.
  • Ensure sales and finance teams are enforcing agreed credit limits for each customer.
  • Target the debtors that owe you the most money and are the most overdue. Invest effort to recover these outstandings (the probability of getting paid reduces the longer an account ages).
  • Optimise your invoice template with Pay Now buttons (so customers can click and pay).
  • Issue invoices to customers promptly after receiving their sales order.
  • Shorten the time to payment by automating payment reminders. Reminders are effective but time-intensive if your staff have to manually prepare and email them.
  • 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.
  • Be prepared to engage third party debt collection or legal services.
  • Review customer satisfaction and address any disputes or issues impacting prompt payment.

Another great measure to use—but more complex to calculate—is the Collection Effectiveness Index. We’ll cover that one in another post.

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