Understanding Accounts Receivable Turnover Ratio: Definition, Formula and Examples

Understanding Accounts Receivable Turnover Ratio

Table of Contents

The efficiency with which a business is able to collect on its receivables or the credit it gives to clients is measured by the Accounts Receivables Turnover. The ratio also counts the number of times a company’s receivables are turned into cash over a specific time period. It is possible to determine the Accounts Receivables Turnover on an annual, quarterly, or monthly basis.

Accounts Receivables, which businesses issue to their clients, are essentially short-term, interest-free loans. If a business makes a transaction to a customer, it may extend terms of 30 or 60 days, giving the customer between 30 and 60 days to pay for the item.

What is the Accounts Receivable Turnover Ratio?

Understanding Accounts Receivable Turnover Ratio

Accounts Receivables Ratios are An accounting measure used to quantify how efficiently a company is in collecting receivables from its clients.

The average number of times a company collects its accounts receivable balance is measured by the Accounts Receivables Turnover. It is a measurement of how well a business manages its line of credit process and collects unpaid bills from customers.

A company’s Accounts Receivables Turnover is higher for an efficient business and lower for an inefficient one. This indicator is frequently used to compare businesses in the same sector in order to determine whether they are on par with their rivals.

How to Calculate Accounts Receivables Turnover

The Accounts Receivables Ratios is the relationship between net credit sales and average Accounts Receivables:

Understanding Accounts Receivable Turnover Ratio

Net Credit Sales (CR)

The numerator of the Accounts Receivables Turnover Ratio is net credit sales, the amount of revenue earned by a company paid via credit. This figure includes cash sales as cash sales do not incur accounts receivable activity. Net credit sales are computed as gross credit sales less any remaining reductions from customer returns or sales discounts.

It’s crucial that the calculation employs a constant time period. Consequently, only a certain time period should be included in the net credit sales (i.e. net credit sales for the second quarter only). This amount should be considered in the computation as it relates to the activity being examined, should returns occur in a subsequent period.

Average Accounts Receivable (AR)

The average balance of accounts receivable serves as the denominator of the Accounts Receivables Turnover Ratio. The average of a company’s beginning and ending accounts receivable balances is typically used to calculate this.

The average balance of accounts receivable at the conclusion of each day may be easily extracted by businesses with more complicated accounting information systems. The business can then take the average of these balances, but it needs to be careful because daily entries could modify the average. The average Accounts Receivables balance should only span a relatively limited time period, just like when computing net credit sales.

Accounts Receivables Turnover in Days

The Accounts Receivables Turnover in days shows the average number of days that it takes a customer to pay the company for sales on credit.

The Accounts Receivables Turnover Formula in days is as follows:

Accounts Receivables Turnover in days = 365 / Accounts Receivables Ratios

Determining the Accounts Receivables Turnover in days for Trinity Bikes Shop in the example below:

Understanding Accounts Receivables Turnover Ratio

Receivable Turnover in days = 365 / 7.2 = 50.69

As a result, it takes the typical client 51 days to settle their account with the retailer. The Accounts Receivables Turnover in days calculated above would suggest that the typical customer makes late payments if Trinity Bikes Shop has a policy for payments made on credit, such as a 30-day policy.

Example of the Accounts Receivables Turnover Ratio

A retail establishment called Trinity Bikes Shop offers bicycles and biking accessories. John, the CEO, decides to offer credit to all of his clients in response to decreased cash sales. There were $100,000 in gross credit sales during the fiscal year that concluded on December 31, 2017, and there were $10,000 in refunds. For the entire year, the accounts receivable were $10,000 at the beginning and $15,000 at the end. John is curious in how frequently his business collects its annual average of Accounts Receivable.

Understanding Accounts Receivables Turnover Ratio

Therefore, over the course of the fiscal year that ended on December 31, 2017, Trinity Bikes Shop recovered its average accounts receivable about 7.2 times.

Accounts Receivable Turnover Ratio Formula

The Accounts Receivables Turnover Formula is used to determine how frequently an account will be paid. The greatest method to prevent bad debt is frequently to turn over receivables more quickly. This lowers the possibility of a bad debt loss for the business.

The formula for accounts receivable turnover is:

Understanding Accounts Receivables Turnover Ratio

Accounts Receivables Turnover Ratio Formula (AR) can be calculated by dividing the Net Credit Sales (CR) by the Average Account Receivables (AR).

Note: Average Accounts receivable = the starting and ending accounts receivable sums over a given time (such as quarterly or monthly), divided by 2.

Understanding Accounts Receivables Turnover Ratio

Net credit sales are cash to be collected later. Net credit sales = Credit sales – Sales returns – Sales allowances.

Understanding Accounts Receivables Turnover Ratio

The higher the Accounts Receivables Turnover Ratio, the faster a company converts credit to cash. A high ratio also means that the receivables are more likely to be paid in full.

How to Interpret Accounts Receivable Turnover Ratio

The efficiency ratio known as the Accounts Receivables Turnover Ratio serves as a gauge of a business’s financial and operational performance. A high ratio is preferred since it shows how frequently and effectively the business collects accounts receivable. A high turnover rate for accounts receivable also suggests that the clientele is of the highest caliber and is capable of making prompt payments. A high ratio may also indicate that a conservative credit policy, such as net-20 days or even net-10 days, is used by the company.

A Low Accounts Receivable Turnover, on the other hand, may indicate that the company’s collection efforts are ineffective. This can be a result of the business giving credit conditions to unworthy clients who are struggling financially.

Low Accounts Receivables Turnover can also mean that the business is extending its credit policy too far. It occasionally occurs in earnings management, where managers extend a very liberal credit policy in an effort to increase sales. Due to the time value of money principle, a company essentially loses more money or has less value in its sales the longer it takes to collect on credit purchases. A corporation is therefore thought to suffer from a low or deteriorating Accounts Receivables Turnover Ratio.

Comparing a company’s ratio to that of its rivals or other like-minded businesses within its industry is helpful. Instead of examining the statistic in isolation, comparing a company’s ratio to those of other similar firms will give a more insightful study of the company’s performance. For instance, if the average ratio for a firm’s industry is two, a company with a ratio of four, which is not necessarily a “high” number, will appear to be performing significantly better.

The outcome can be understood as:

1/ The number of times per year that a company collects on its debts.
2/ A measure of how fast a company is paid by its customers.
3/ The rate at which a company sells its products or services per year compared with the rate at which it collects on those sales.

The higher the Accounts Receivables Turnover, the better it is for the company. There are fewer bad debts when accounts receivable are paid off fast. Having money coming in for their other expenses equals less risk for the business.

Due to recent technological advancements that have made it simpler for clients from other countries to make online purchases without incurring additional fees, the turnover of accounts receivables has increased globally. Automation of AR is another key strategic player in the process of streamlining. Accounts Receivables Turnover can therefore be thought of as a measurement of how quickly a business transforms credit into cash.

What is a good Accounts Receivable Turnover Ratio?

The Accounts Receivables Turnover Ratio in accounting gauges how effectively a business controls its customer credit risk. This ratio indicates how frequently a company may collect unpaid invoices within a calendar year.

However, it is not as simple to analyze the accounts receivable turnover ratio as one might believe. The Accounts Receivables Turnover measures more than just how successfully a company collects its unpaid bills. Additionally, it is based on how rapidly fresh sales are generated. Overly lenient borrowing terms may have an effect on the company’s cash flow and profitability.

The higher the Accounts Receivables Turnover Ratio, the more efficiently the organization collects past-due debts. This ratio is often measured in times per annum and can also be used to assess a company’s creditworthiness.

How can you keep your Accounts Receivables Turnover Ratio high?

Monitoring your present cash situation and maintaining the high Accounts Receivables Turnover Ratio necessary for successful debt collection and overall creditworthiness requires a sound cash flow management plan.

Optimize your Accounts Receivable Turnover Ratio

The secret to improving your Accounts Receivables Turnover rate is to increase cash flow. When compared to a business with a lower turnover rate, a higher turnover rate typically means more consistent cash flow and better financial health. Because of the high turnover rate of accounts receivable, businesses have less time to turn over their cash.

What can you do to increase your turnover rates for accounts receivable?

Look at the balance between the ratio of receivables to payables as you optimize your Accounts Receivables Turnover rates:

  • If this ratio is large, it could be a sign of the company’s poor commercial credit standing. It also suggests that the company’s ability to borrow money is constrained.
  • The other balance is between the turnover of inventories and receivables. Your revenue will increase as you flip over your goods more quickly.

The bottom line?

Increasing your Accounts Receivables Turnover rate could result in significant overall financial savings.

The amount of times a business turns its outstanding receivables into cash over the course of a given period is measured by the Accounts Receivables Turnover Ratio. Accounts Receivables Turnover is usually expressed as a ratio of annual credit sales to average accounts receivable balance. This number measures how many times on average the company can “turn over” (collect) its total receivables each year. The higher the ratio, the more quickly a company can turn over its total receivables. This number has an inverse relationship with the days in accounts receivable.

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