Receivables Turnover Ratio Defined: Formula, Importance
Posted by Harshal on October 19th, 2022
The accounts receivable turnover ratio, also known as the debtor’s turnover ratio, is an efficiency ratio that measures how efficiently a company is collecting revenue – and by extension, how efficiently it is using its assets. The accounts receivable turnover ratio measures the number of times over a given period that a company collects its average accounts receivable
Interpretation of Accounts Receivable Turnover Ratio
The accounts receivable turnover ratio is an efficiency ratio and is an indicator of a company’s financial and operational performance. A high ratio is desirable, as it indicates that the company’s collection of accounts receivable is frequent and efficient. A high accounts receivable turnover also indicates that the company enjoys a high-quality customer base that is able to pay their debts quickly. Also, a high ratio can suggest that the company follows a conservative credit policy such as net-20-days or even a net-10-days policy.
On the other hand, a low accounts receivable turnover ratio suggests that the company’s collection process is poor. This can be due to the company extending credit terms to non-creditworthy customers who are experiencing financial difficulties.
Additionally, a low ratio can indicate that the company is extending its credit policy for too long. It can sometimes be seen in earnings accounts receivables management, where managers offer a very long credit policy to generate additional sales. Due to the time value of money principle, the longer a company takes to collect on its credit sales, the more money a company effectively loses, or the less valuable are the company’s sales. Therefore, a low or declining accounts receivable turnover ratio is considered detrimental to a company.
It’s useful to compare a company’s ratio to that of its competitors or similar companies within its industry. Looking at a company’s ratio, relative to that of similar firms, will provide a more meaningful analysis of the company’s performance rather than viewing the number in isolation. For example, a company with a ratio of four, not inherently a “high” number, will appear to be performing considerably better if the average ratio for its industry is two.
How to Calculate the Accounts Receivable Turnover Ratio
To calculate receivables turnover, add together beginning and ending accounts receivable to arrive at the average accounts receivable for the measurement period, and divide into the net credit sales for the year. Net credit sales are those sales generated on credit, minus all sales returns and allowances. The formula is as follows:
Net Annual Credit Sales ÷ ((Beginning Accounts Receivable + Ending Accounts Receivable) / 2)
Example of the Accounts Receivable Turnover Ratio
The controller of ABC Company wants to determine the company's accounts receivable turnover for the past year. In the beginning of this period, the beginning accounts receivable balance was 6,000, and the ending balance was 4,000. Net credit sales for the last 12 months were ,500,000. Based on this information, the controller calculates the accounts receivable turnover as:
,500,000 Net credit sales ÷ ((6,000 Beginning receivables + 4,000 Ending receivables) / 2)
= ,500,000 Net credit sales ÷ 0,000 Average accounts receivable
= 10.0 Accounts receivable turnover
Thus, ABC's accounts receivable turned over 10 times during the past year, which means that the average account receivable was collected in 36.5 days. Assuming that ABC’s normal credit terms were 30 days to pay, the 36.5 days figure represents quite an acceptable collection rate.
Importance of Receivables Turnover Ratio
The accounts receivable turnover ratio communicates a variety of useful information to a company. The ratio tells a company:
- How well a company is collecting credit sales. As a company processes receivable balances faster, it gets its hand on capital faster.
- What collateral opportunities a company may have. Some lenders may use accounts receivable as collateral; with strong historical accounts receivable activity, a company may have greater opportunities to borrow funds.
- When it might be able to make large capital investments. A company can project what cash it will have on hand in the future when better understanding how quickly it will convert receivable balances to cash.
- How sufficiently a company is evaluating the credit of clients. If a company's accounts receivable turnover ratio is low, this may be an indicator that a company is not reviewing the creditworthiness of its clients enough. Slower turnover of receivables may eventually lead to clients becoming insolvent and unable to pay.
- How it is performing over time. When analyzing financial ratios of a single company over time, that company can better understand the trajectory of its accounts receivable turnover.
- How it is performing compared to its competitors. When analyzing financial ratios of several different but similar companies, a company can better understand whether it is an industry-leader or whether it is falling behind.
Problems with the Accounts Receivable Turnover Ratio
Here are a few cautionary items to consider when using the receivables turnover measurement:
Total Sales Used
Some companies may use total sales in the numerator, rather than net credit sales. This can result in a misleading measurement if the proportion of cash sales is high, since the amount of turnover will appear to be higher than is really the case. This is a particular concern in businesses that generate a robust amount of cash sales in proportion to their credit sales.
Restrictive Credit Policy Used
A very high accounts receivable turnover number can indicate an excessively restrictive credit policy, where the credit manager is only allowing credit sales to the most creditworthy customers, and letting competitors with looser credit policies take away other sales. A restrictive credit policy is not a good idea when product margins are high, since it can result in the loss of a substantial amount of profit. In this case, it would be better to loosen the credit policy in order to increase sales to lower-quality customers, since the incremental amount of profit gained will exceed the incremental gain in bad debts.
Denominator Calculation Method
The beginning and ending accounts receivable balances are for just two specific points in time during the measurement year, and the balances on those two dates may vary considerably from the average amount during the entire year. Therefore, it is acceptable to use a different method to arrive at the average accounts receivable balance, such as the average ending balance for all 12 months of the year.
Seller Mistakes Causing Nonpayment
A low receivable turnover figure may not be the fault of the credit and collections staff at all. Instead, it is possible that errors made in other parts of the company are preventing payment. For example, if goods are faulty or the wrong goods are shipped, customers may refuse to pay the company. Thus, the blame for a poor measurement result may be spread through many parts of a business. If so, be sure to drill down into the reasons given by customers for non-payment, and forward this information to senior management for further action.
Advantages and Disadvantages of Accounts Receivable Turnover Ratio
Below are some pros and cons of the ART ratio, which are as follows –
- It can help in understanding the credit policy of a company and its bargaining power among its customers.
- It indicates the quality of customers that the company is dealing with.
- In the case of seasonal businesses with a peak period in the middle of the year, the ratio may not reflect the true picture as the calculation is based on accounting figures at the start and at the end of the year.
- The use of entire sales in place credit sales results in an inflated ratio that fails to represent the actual collection management of a company.