When it comes to gauging the efficiency of your business, several formulas can help find out how well you are managing the collection of debts within your business. One such measure is the Accounts Receivable Turnover Ratio.
The accounts receivable turnover ratio helps evaluate how effectively a business can recover its payments from its outstanding invoices.
This is an important source of cash and, if appropriately managed, can allow the business to run successfully without any liquidity issues.
However, if there are issues in payment collection, it might lead to cash flow and liquidity problems. To avoid those issues, it is important to use metrics such as account receivable turnover, allowing the business to measure how efficiently it is handling collections.
Accounts receivable turnover measures how effectively a business manages customer credit and collects payments from them. It quantifies how quickly the company is able to receive payments from its customers during an accounting period.
The result gained from the formula indicates the number of times the business collects payments from its customers in an accounting year.
To measure this efficiency, the accounts receivable turnover is calculated using an accounting formula which will be discussed next.
The accounting formula used for calculating accounts receivables turnover ratio requires net credit sales during an accounting period and average accounts receivables.
The formula can be written down as:
Net credit sales / Average Accounts Receivable
The first step in calculating the accounts receivables turnover ratio is calculating the net credit sales for the company. This includes all sales made on credit and will not include any cash sales made during an accounting period.
Further, the sales returns or allowances must also be deducted to arrive at the amount of net credit sales for the period. These amounts can be found in the income statement and the balance sheet of the business.
The next step in calculating the accounting receivable turnover ratio is calculating the average accounts receivables for the period.
The Accounts Receivable is the total of outstanding customer invoices and thus are yet to be paid by the customers. The amount for accounts receivables is listed under the current assets section of the business’s balance sheet.
The average accounts receivables will require the ending balance from last year and the current year’s accounts receivables.
Further, it can be calculated by adding the balance of accounts receivable at the beginning of the current year (or ending balance of last year’s accounts receivable) to the balance of accounts receivables at the end of the current year and then dividing the total by 2 to arrive at the average accounts receivables for the period. This can be written as:
(Opening Accounts Receivable + Closing Accounts Receivable) / 2
The final step in calculating the accounts receivable turnover is dividing the value obtained for net credit sales by average accounts receivable for the year. This will give the result for the accounts receivable turnover ratio.
When calculating the accounts turnover ratio, a higher ratio means a higher turnover which indicates that the business is able to collect payments from its customers quickly.
However, when the ratio is lower, it means that the business is not able to collect payments from outstanding invoices quickly and there are delays in receiving them.
The following example will explain the concept of accounts receivable turnover ratio in more detail:
Consider a company ABC with credit sales of $120,000 and $20,000 in returns. The opening balance of accounts receivable, the total of outstanding invoices at the beginning of the year, was $25,000 and the closing balance of Accounts Receivables was $25,000. We must now determine the accounts receivable turnover.
To calculate the accounts receivable turnover, the first step is to calculate the net credit sales. This would be done by deducting sales returns from the credit sales.
Therefore, net credit sales= Credit sales – returns
$120,000 – 20,000= $100,000
As the next step to calculate the average accounts receivables, the opening and the closing account receivable balances must be added together and then the sum would be divided by 2.
(25,000 + 25,000)/2 = $25,000
Therefore, the average accounts receivables are $25,000.
In the next step, to calculate accounts receivables turnover, we must divide net credit sales by average accounts receivables.
$100,000 / $25,000 = 4
The accounts receivable turnover ratio is 4 times.
This implies that the business is able to collect outstanding invoices from its customer 4 times a year.
It is generally preferable for this ratio to be higher as this would mean that the business is able to collect payments from its customers quickly and does not have to go through any liquidity issues.
However, companies whose accounts receivable turnover ratio is too high when compared with other companies in the industry, are not necessarily performing well in terms of efficiency in payment collection.
When too high, and accounts receivable turnover could implicate that the company’s credit terms are too strict and could mean that the company is losing out on potential customers and sales.
When the ratio is too low, companies need to revise their credit policies to make them less lenient and assess the repayment capability of their customers.
To sum up, the accounts receivables turnover ratio is a metric for determining the efficiency of the company is being able to collect payments from its credit customers or accounts receivable and therefore the company’s capability to manage credit extensions to its customers.
It uses an accounting formula consisting of net credit sales and average accounts receivables to arrive at the ratio.
A higher accounts receivable turnover ratio is generally regarded as good but companies whose accounts receivable turnover ratio is too high should be careful that their credit terms are not too aggressive.
Companies with lower accounts receivable turnover should focus on improving their payment collection mechanism and credit terms.