In a previous article, we discussed the importance of Days Sales Outstanding (DSO). Similarly, Accounts Receivable Turnover is another important metric that tracks and measures the effectiveness of your AR collections efforts. Let’s take a look at what receivables turnover is, how to calculate the turnover ratio, and what it all means to your cash collection cycle.
What is Receivables Turnover?
The accounts receivables turnover ratio is used to measure how efficient and effective your company is in collecting on outstanding invoices in AR. In other words, the receivables turnover ratio quantifies how well you’re managing the credit you extend to customers and how quickly that short-term debt is paid.
Accounts Receivable Turnover Formula and Calculation
In its simplest form, the accounts receivable turnover formula looks like this:
Net Credit Sales / Average Accounts Receivable
But you might be asking yourself “How and where do I find those numbers?” Here’s how …
1. Determine Net Credit Sales
The first part of the formula, Net credit sales, is revenue generated for the year from sales that were done on credit minus any returns from customers.
Note: the calculation of net credit sales excludes cash sales because they don’t create receivables.
2. Determine Average Accounts Receivable
To get the second part of the formula (the denominator), add the value of accounts receivable at the beginning of the year to the value at the end of the year and then divide by two.
3. Calculate the Turnover Ratio
Divide the value from step 1 by the value from step 2 and voila! You have your accounts receivable turnover ratio for the year.
Receivables Turnover Example
As an example, let’s say you want to determine your receivables turnover last year where your company had a beginning balance of $275,000 and an ending balance of $325,000 in accounts receivable. Net credit sales for that same year was $2,500,000.
Here’s how you would calculate receivables turnover in this example:
Average Accounts Receivable: ($275,000 + $325,000) ÷ 2 = $300,000
$2,500,000 (Net Credit Sales) ÷ $300,000 (Avg A/R) = 8.33 Receivables Turnover
Note: 8.33 is the receivables turnover for the year in our example. But you can do the same calculation for a month, quarter or any other period of time by adjusting the net credit sales and average accounts receivable inputs accordingly.
What Does Receivables Turnover Ratio Indicate?
Finance managers and executives use the accounts receivable turnover ratio as a way of tracking and measuring cashflow and how quickly the company is converting credit sales into cash that can be used in the business. This is particularly important for small business where late or delayed customer payments have a disproportionately adverse impact on operations.
When evaluated over a period of time, receivables turnover can also help to spot trends. Receivable turnover can identify if it is taking longer to collect payments from customers and help determine whether credit and collections policies need to be adjusted.
A high receivables turnover ratio often indicates a conservative credit policy and/or an aggressive collections department. It can also mean that your company does business with a number of high-quality customers that respect your cash flow and pay their invoices in a timely manner.
On the other hand, a low turnover ratio can indicate that there’s opportunity to more aggressively collect on older, outstanding receivables that are tying up working capital unnecessarily. At the same time, low receivables turnover may be caused by a loose credit policy, an inadequate collections effort, and/or a large proportion of customers having financial difficulties.
How Can I Improve Receivables Turnover?
- Collect payment up front or on delivery - some customers are willing and all you have to do is ask. In other cases, offering a small discount may do the job.
- Make payment easy – offering multiple payment options that are quick and easy can go a long way in improving receivables turnover. If customers have to “cut a check” or call in to process a credit card payment, you’re putting up barriers that may delay payment.
- Credit checks and payment terms – accounts receivable turnover is often driven by your customers' ability to pay invoices on time. Therefore, any effort to improve your turnover ratio must address customer credit risk and define payment terms based on that creditworthiness.
- Automate and digitize - One simple thing you can do is to convert paper to email with electronic invoicing. Just this one step can help businesses reduce the collection cycle by 2-6 days. In addition, AR management software like Collect-IT allows you to send email reminders that are automatically triggered at certain intervals. Because sometimes, customers simply forget the invoice is outstanding.
- Use Collections Software – improving receivables turnover, minimizing bad debt, and getting paid on time starts with automating your accounts receivable management process. AR software like Collect-IT provides the tools and insights to manage collections, analyze trends, make certain that nothing slips through the cracks, and ensure that your customers pay on time, every time.