A quick and easy indicator of how a business is tracking in its collection of credit sales is the accounts receivable turnover ratio, also known as the A/R turnover ratio. The accounts receivable turnover ratio is a simple formula an accountant can produce in seconds from the accrual accounts. It’s a good measure of future cash flow expectations from credit sales. Importantly, changes in A/R turnover ratio can point towards trouble in cash flow, or on the upside, an improvement in collections.

Calculating accounts receivable turnover ratio

The best thing about the A/R 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.

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 A/R turnover ratio is 8. (1,000,000 / 125,000). Company ABC turns over its accounts receivables 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.

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

The best way to determine if a business’ Accounts Receivable Turnover 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 A/R 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 A/R turnover ratios (some industries are routinely slower to pay than others).
  3. Specified credit terms (if the Accounts Receivable Turnover Ratio indicates a much longer collection time than that agreed with customers, something’s not working).
  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 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).

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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’s a positive for cash flow. That’s a great goal to achieve, but not at the expense of reduced annual sales or customers, so an ‘improved’ 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 assessed and issued to customers based on good risk management practices (for example, do credit checks on new customers to assess the risk of late or default payments; and undertake credit monitoring).
  • Ensure sales and finance teams are enforcing agreed credit limits for each customer.
  • Find the largest and oldest debtors and invest effort to make a cash recovery (the longer an account ages, the probability of getting paid reduces).
  • Improve invoicing processes by using best practice invoice templates and issuing invoices immediately after sales.
  • Improve overdue collections by systemising and automating time intensive follow-ups. Consistent and polite follow-up works.
  • 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 enact debt collection or legal recourse activities.
  • 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.

To learn how the features in ezyCollect can improve your accounts receivable turnover ratio, schedule a demo today.