Managing your small business’s daily operations is hectic enough without the added concern of performing routine accounting work for your company, a task many small business owners take on without much outside help.
While the responsibility of keeping your financial obligations in order and following proper accounting procedures can seem daunting, there is a simple and surprising tip you should know in order to make your life easier and your business healthier: if you keep track of the money coming in from customers, you won’t overspend more than you can afford at a given time. To do so, many owners perform a simple calculation to determine their Accounts Receivable Turnover Ratio or Receivables Turnover Ratio.
A turnover ratio is used to quantify your company’s success at collecting receivables, or money owed to your business by its clients. The figure is a measure of how effectively your firm has organized its payment schedules and collection practices, as well as an indication of whether or not your business has successfully managed the credit extended to clients and how quickly the related short term-debts are resolved. Keeping track of your receivables turnover ratio is key to ensuring that your credit policies are well-thought-out and that no sales go unfulfilled for too long.
What is the Receivables Turnover Ratio?
Generally, the Receivables Turnover Ratio measures how well a company is issuing and managing its short-term debts in the form of outstanding invoices. Businesses that operate using accounts receivable ultimately extend interest-free loans to their customers, as clients are given 30 or 60 days to complete a payment, with no penalties for delayed payments up until the given deadline. The receivables turnover ratio tells you how often your firm collected outstanding payments over a specified period, and whether, on average, your clients complete their payments early, late, or on time. Weighed against other firms’ ratios, you are able to see how your credit policies compare, and whether or not your market performance can be tied to a pattern or trend in accounting procedures.
What is the Accounts Receivable Turnover Ratio Formula?
The formula for calculating your Accounts Receivable Turnover Ratio is fairly straightforward: you divide your Net Credit Sales over a period of time by your average accounts receivable over that same period.
Your firm’s net credit sales figure is the sum of the values of all sales made on credit — meaning that payment was delayed or extended — over a period, minus any customer returns or refunds offered on credit sales. To arrive at your net credit sales over a given period, take the [ (total value of sales made on credit) – (the total value of returned sales) – (the total value of sales allowances given on credit sales) ].
Your average accounts receivable is what it sounds like: the average amount of outstanding value in your accounts receivable across the time frame in question. To arrive at this figure, simply add the values of your accounts receivable at the beginning and end of the term, and divide by two. Doing so lets you see the average value of unpaid accounts at any given time throughout the period.
How to Calculate Accounts Receivable Turnover
Here’s an example calculation for a company’s accounts receivable turnover, which can be measured over any period of time, from month to quarter to a full year:
Consider a company which on January 1st, at the start of the year, had $60,000 in accounts receivables, and on December 31st, at the end of the year, had $70,000. To arrive at their average accounts receivable (ACR) over the year, we calculate: 60,000 + 70,000 / 2 = $65,000 on average in accounts receivable.
Suppose that same company, over the year, had net credit sales of $700,000, meaning that they collected a total of $700,000 on the year from customers that paid with a credit plan of some sort.
Taking this Net Credit Sales figure, and the ACR from above, we can determine the business’s Accounts Receivable Turnover for the year:
Net Credit Sales / ACR = Accounts Receivable Turnover Ratio
$700,000 / $65,000 = 10.77
An accounts receivable turnover ratio of 10.77 means that, over the course of the year, the company collected its average receivables 10.77 times. Based on this measurement for past years, this could either be a sign of improved credit collection policies or a lapse in financial management.
Using that ratio, we can also determine the average repayment period for customers over the year. Taking 365 days / 10.77 = 33.89 days per payment. If this company operates with a 30-day payment schedule, then this indicates that the average client is late on their payment; likewise, if the typical credit period is 60 days, then this shows efficient collection practices on behalf of the company.
What is a Good Accounts Receivable Turnover Ratio?
Generally, the higher your accounts receivable turnover ratio, the better. This is because a high ratio indicates that your business is frequently converting outstanding receivables into cash, and practicing efficient credit management by periodically and consistently reducing its short-term debts. However, there are a couple of non-significant reasons why this ratio may be lower. For example, if your business sees a seasonal shift in sales due to tourism or weather conditions, your receivables turnover ratio will vary widely if calculated on a monthly or quarterly basis. While the accounts receivable turnover ratio is a fairly consistent indicator of a business’s efficiency in extending and using credit, it is ultimately just a single metric of a company’s general health, and shouldn’t be overemphasized when discussing areas other than a firm’s credit practices.
High Receivables Turnover Ratio
There is no consistent threshold for what is considered a “high” receivables turnover ratio, but you can weigh your own business’s ratio against those of industry competitors to determine whether your credit management is relatively on par, better, or worse than the market average. Generally speaking, a higher ratio than comparable companies indicates that a given business has an efficient method of collecting receivables and customers who complete payments on time. Maintaining a high ratio is an indication that your company is not losing out on value by allowing payments to go unfulfilled for too long, a practice that effectively results in lost time and income for the firm over time.
Low Receivables Turnover Ratio
Conversely, a low receivables turnover ratio is an indication that a company may frequently extend credit to customers unable or unwilling to fulfill their payment obligations, or that the business practices poor collection practices on credit sales. By extension, a low turnover ratio may be a sign that a business is at risk of amassing high levels of debt due to customer defaults.
Why is Your Accounts Receivable Turnover Ratio Important?
Understanding your business’s accounts receivable turnover ratio can help shed light on a number of measurements of your company’s wellbeing. For example, if your business has a low turnover ratio over the last few years, you may want to consider adopting your credit policies to mandate higher deposits or more strict repayment practices; or, if you can afford it, it may be an indication that you should hire some outside accounting help to examine your receivables and year-end statements.
Conversely, if you calculate a high turnover ratio for your business relative to its competitors, but the other firms in question actually outperform your business in other financial metrics, then you may want to consider loosening your restrictions on credit. While the benefit to efficient credit management is a higher turnover ratio and a more trustworthy balance sheet, a drawback can be that it dissuades certain customers from approaching your business out of fear of rejection. There’s always a balance between the two, even if it’s generally better to err on the side of a higher ratio when attempting to attract investors or position your business for growth.
And finally, your accounts receivable turnover ratio can impact your business’s ability to qualify for small business financing in a number of forms. For one, banking representatives and lenders will likely be disinclined from lending to your firm if it has a lower ratio and is at risk of accumulating debt, and more likely to do so if you routinely collect outstanding payments. Alternatively, if you’re pursuing forms of financing that depend on a third party’s assumption of your short-term debts, like invoice factoring, it’s in your best interest to shore up your credit policies and present an efficient method of collection through a higher turnover ratio. , a simple method of receiving up-front cash by selling outstanding receivables.
Author:
Jeffrey Bumbales
Director, Marketing & Strategic Partnerships at Credibly
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