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.
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.
In its simplest form, the accounts receivable turnover formula looks like this:
But you might be asking yourself “How and where do I find those numbers?” Here’s how …
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.
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.
Divide the value from step 1 by the value from step 2 and voila! You have your accounts receivable turnover ratio for the year.
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.
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.
Here are a few tips that may help improve your Accounts Receivable process to improve cash flow while reducing the need for sending collection letters and making collection calls: