Are you familiar with the definition of accounts receivable turnover and do you know its role in the success of your business?
Understanding the basic principles of accounts receivable and accounts receivable turnover is necessary for more than just a company’s accounting team.
Business owners should have a foundational knowledge of these terms and concepts and how they apply to their business if they want to have the best available information for making decisions.
“It is possible for a company to be profitable on paper, but have difficulty staying in business simply because the cash flow is not available to sustain day-to-day expenses and investments.” says Brian Shannon, financial consultant and Chief Strategy Officer at Dolphin Enterprise Solutions Corporation.
Accounts receivable turnover sounds complicated and intimidating but once you understand the concept it can easily be used to improve your business.
Accounts Receivable Turnover Defined
Accounts receivable turnover is an efficiency ratio used to measure the effective use of customer credit and subsequent debt collection.
It tells a business if it is providing credit to customers which are then being repaid on time.
Sometimes called debtor’s turnover ratio, this accounting measurement quantifies how effectively a business is leveraging its assets.
How to Calculate Accounts Receivable Turnover
The AR turnover formula requires you divide the net credit sales by the average accounts receivable for the predefined tracking period.
Accounts Receivable Turnover Formula
AR Turnover = Net Credit Sales / Average Accounts Receivable
NOTE: It is important to remember you are only using credit sales in this formula.
Using total sales rather than net sales will inflate the ratio and will not accurately reflect the credit situation of the business.
Net credit sales are the number of credit sales minus refunds and returns.
Net Credit Sales = Sales on Credit – Sales Returns
Cash sales are not used of course, since the purpose of calculating the accounts receivable turnover is to determine the efficacy of your credit offers.
Average accounts receivables is calculated by adding the receivables from the beginning and ending of the predefined period and dividing by two.
Average Accounts Receivables = Beginning AR + Ending AR / 2
How Often to Calculate AR Turnover
The receivables turnover ratio is sometimes calculated on an annual basis, but it could also be calculated quarterly or monthly to identify trends more quickly.
It is possible for the ratio to vary dramatically over the course of a year, which makes it imperative the dates are chosen with the monthly accounts receivable averages carefully taken into consideration.
The value of monitoring the accounts receivable turnover ratio is most evident when they are carefully compared to previous periods to determine any new trends that could be negatively impacting the bottom line of the business.
If a business has a low number of collections they will have a low ratio while one with high numbers will have higher ratios.
For example, if a business had $200,000 in net credit sales for the year with average receivables of $50,000, the accounts receivable turnover ratio would be four (200,000/50,000=4).
Using the example above, the business is collecting the average receivables four times each year.
Stated another way, they are cycling through the accounts receivable about once per quarter.
The higher the accounts receivable turnover ratio, the greater the chance customer debt is being repaid quickly which means cash flow is optimized and business debts and responsibilities are funded more quickly.
“We find that organizations with less efficient Accounts Receivable collections – or lower turnover rates – also incur higher rates of delinquent receivables which can lead quickly to bad debt write-offs,” adds Shannon.
Accounts Receivable & the Time Value of Money
Accounts receivable are money owed to a business on an interest-free credit agreement; this money is considered an asset.
It is important to note that while accounts receivable are considered an asset, they do not become functionally useful in the form of cash until collected from the client.
Businesses are essentially offering interest-free loans to their customers!
Because of the time value of money (TVM) principle which states the value of money received in the future is less than the value of money received today, businesses lose money the longer it takes for them to collect on credit sales.
The longer between the time a business provides a product or service and the time they are paid, the longer they are prevented from investing further in the growth of their business.
Trade Receivables vs. Non-Trade Receivables
There are two types of receivables which should not be confused; trade receivables and non-trade receivables.
Trade receivables are credits owed to your business by clients who have purchased goods or services.
This is what is used when calculating the accounts receivable turnover ratio.
Non-trade receivables are reimbursements owed outside of customer invoices such as tax refunds and insurance reimbursements.
These are NOT used when calculating the turnover ratio.
Average Collection Period Ratio
This formula works with the accounts receivable turnover ratio to determine the quality of a company’s receivables as well as the efficacy of their credit and collection policies.
The average collection period is calculated by dividing the number of days in a period by the accounts receivable turnover and is sometimes called the ratio of days sales outstanding (also known as DSO).
Average Collection Period = Days x AR Turnover / Credit Sales
It provides the average number of days needed before receivables are converted into cash.
The number of days used in the calculation is usually 365, but maybe any number if it is reflective of the receivables turnover duration.
The difference between the two is substantial so it is imperative the number of days used in the calculations for both time periods be the same.
Accounts Receivable Turnover Decoded
The AR turnover ratio also makes it possible to calculate the speed of payments business is likely to receive, how well the business is choosing who to offer credit to, and how effective the customer debt management strategy is.
Mario Melgar, Director, Capgemini Business Services offered the following commentary:
“From out of the box applications to high-end ERPs, there are many tools available to support the AR activity. Technology’s main contributions to the AR role include higher levels of automation, process adherence, interaction and control.”
He also suggests, “Some very simple, but often underestimated, turnover ratio drivers from a process perspective are: effective order entry, simplified invoices, making sure every customer understands what they are being billed, and making it easy for customers to pay their bill.”
In addition, Melgar says that “Choosing the right technology, aligning processes with business priorities and, very importantly, having effective communication across the entire supply chain will enable a company to reach its turnover ratio target.”
What Does High Accounts Receivable Turnover Mean?
You’ll need to examine your business financials to figure out the specific meaning of your AR turnover, but a high ratio typically indicates one or more of the following:
- The business operates primarily on a cash basis or with relatively short payment terms.
- Payments from debt are received as expected and cash flow is stabilized or increased.
- Debt collection methodology is effective.
- Credit is being extended to appropriately selected customers and less bad debt is financed.
- Customers are repaying their debt quickly which allows them to leverage their credit line for additional purchases.
While a high turnover ratio is usually desirable, there are hidden dangers in a rate that is too high.
If the ratio is excessively high it may mean current policies are too aggressive and can cause customer dissatisfaction.
“The effective use of payment terms is critical to increasing sales over the long term.
The credit team has the task of assessing the viability of the customer to repay the credit that is extended, but they must also work with the sales team to drive strategies that will help to balance the relative risk with the benefit of increasing top-line revenue,” says Shannon.
An example of this is a repayment window that is too narrow and may result in clients looking for options that afford them more repayment flexibility.
While it would be good for the short-term turnover ratio, it could be harming longer term revenue capabilities.
Overly strict credit policies may also result in fewer sales to potential clients who are slightly under the limit for acceptable credit scores.
For example, if a business has been turning away clients who fail to meet one criterion but far exceed expectations in other ways this is a missed opportunity.
Making credit available to even a slightly higher percentage of prospective customers can help a business grow even if it does decrease their turnover ratio slightly in the short term.
If the number of sales is not satisfactory and a business has a high accounts receivable turnover ratio, they may benefit from loosening the requirements to extend credit to increase sales even if this lowers the ratio slightly.
What Does Low Accounts Receivable Turnover Mean?
A low accounts receivable turnover ratio almost always indicates the credit practices of a business need to be improved:
- Established collection policies need to be reviewed in detail and possibly replaced.
- Credit is being extended to inappropriately selected customers and the application process may need to be revised.
- Debt which is uncollectable is harming cash flow.
- Customers may be struggling to meet their financial obligations to the business which decreases the likelihood they will have the ability to leverage their credit line for additional purchases.
It is important to note that a low accounts receivable turnover ratio may also be identifying issues within the business that are not due to problems with the credit or collections policies.
If the ratio is low and credit and collections policies seem to be effective, all processes should be evaluated.
In some instances, a low ratio could be an indicator that the business is failing to satisfy customer expectations. This could be caused
This could be caused by shipping errors, product quality, or customer service.
For example, if your shipping department is consistently mixing up orders and sending clients the wrong item, this decreases customer satisfaction and may also increase the time it takes a customer to receive the right item and remit payment.
Similarly, if your collections team is not following procedures properly the process may appear less effective when it is actually an employee problem rather than a procedural one.
Shannon went on to explain: “Accounts Receivable sits at the bottom of the mountain.
All of the missteps of the processes before it can cause an avalanche of exceptions in managing customer receivables – such as pricing errors, invoicing issues, or incomplete deliveries.
Efficient dispute management and cash application processes will lead to more accurately applied and managed payments which can have a very positive effect on the DSO.
Most importantly, the customer’s account is deemed to be in good standing and can facilitate further purchases on credit.”
Accounts Receivable Turnover – Possible Reasons for Changes
A decrease in the turnover ratio means it is taking longer for collections to be processed.
This could indicate an economic downturn in the industry or the economy at large because clients experiencing cash flow problems typically remit payments later than those who are not struggling with cash flow.
This has a trickle-down effect and may cause your business to have cash flow problems and fall behind on your own debts.
A decrease may also be caused by a difference between the terms you have in place and those which are the industry standard.
For example, if the industry standard is repayment within 45 days and you have a stated expectation of 20 days, clients may naturally remit payment based on their experience with other vendors in the industry.
An increase in the turnover ratio means it is taking less time for collections to be processed; this could indicate an economic upturn.
Realizing this early may position a business to effectively increase their reach through marketing efforts.
How Your Small Business Can Use AR Turnover Ratio
The accounts receivable turnover ratio is a powerful business planning and management tool that can help quickly identify problems before they become systemic.
Monitoring the ratio allows for more precise predictions about upcoming cash flow and allows a business to more accurately budget for business expenses.
Effectively addressing debt collection problems makes it is possible to improve cash flow quickly and provide the capital needed to expand the business.
“Accelerating collections is also possible through the use of early payment discounts.
Offering incentives to your customers to pay early is one way to reduce the outstanding receivables.
But there is, of course, a cost to this, so the financial leadership team must weigh the options of balancing profitability with cash flow for the organization,” adds Shannon.
Improving the ratio could make it easier to obtain a small business loan because some lenders use accounts receivable as collateral.
Small business owners who improve their AR turnover ratio may also be able to increase the collateral they can offer which may, in turn, improve loan terms.
Further, SMBs may leverage the ratio to maximize the efficacy of collection policies.
This may mean taking a more aggressive stance in payment collection or providing incentives for customers who repay their debt quickly.
All that being said, the main benefit of monitoring the accounts receivable turnover ratio is to identify trends that indicate infrastructure problems.
Anomalies in those trends can also help identify bad customer accounts which need closer inspection.
A business which is considering acquiring a competitor can compare the two accounts receivable turnover ratios to help determine if the acquisition is a safe investment.
The Bottom Line
Understanding the accounts receivable turnover ratio allows you to quickly identify problems in credit and collection policies in your small business.
Addressing and rectifying those problems can improve the financial health and the future earning potential of the business.
It measures the liquidity of a business’ accounts receivable, and can be a valuable tool in assessing the overall financial stability of a company.
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