Last updated by
March 1, 2021
Knowing how to read and understand the accounts receivable turnover ratio and other similar ratios will help you make better decisions and avoid disasters.
Calculating the accounts receivable turnover ratio is calculated by dividing net credit sales by average accounts receivable. The higher the number, the more efficient the company is in collecting credit sales.
Knowing how to read and understand the accounts receivable turnover ratio and other similar ratios will help you make better decisions and avoid disasters. Even though accounting numbers are historical in nature, they tell a compelling story you want to hear.
However, in order to paint the full picture, some accounting numbers must be combined, compared or converted into ratios using a formula. These formula conversions are called ratios. The accounts receivable turnover ratio is one such metric that compares the relationship between net credit sales and average accounts receivables to determine how affect a company is in collecting accounts receivables.
Continue reading to discover specifics about the accounts receivable turnover ratio including:
Table of contents
The accounts receivable turnover ratio measures how frequently accounts receivables turnover, or in other words how quickly they are collected.
If your business had an accounts receivable turnover of 4, that would mean you collect your average receivables 4 times a year. The higher the number the better, as that means you are collecting more frequently. The quicker you collect accounts receivables the sooner you have access to the cash.
Here are some examples for perspective.
Typically, the accounts receivable turnover ratio is calculated on an annual basis. It can be calculated more frequently but at a minimum it should be calculated once a year to keep things in check. You could also calculate it on a monthly basis for more timely decision making.
While it is important to calculate the number, it is more important to compare the number to prior years to determine if you are getting better, worse or staying the same. This comparison over time reveals trends and changes that will help you recognize potential problems.
Let’s take a look at the formula again and define each part.
Net credit sales is the total sales amount you sold on credit during the period. If your calculation is for a month, only consider the credit sales for the month. If your calculation is for a year, consider all credit sales for the year.
Since accounts receivable only relates to credit sales it is important to remove any cash sales, otherwise you will calculate an incorrect ratio.
You can calculate net credit sales by taking the beginning sales balance, less the ending sales balance, less any cash sales during the period.
You can find the gross sales number on the profit and loss statement for whatever period you need, then subtract any cash sales.
Average accounts receivable means the average receivable balance during the period. This is calculated by taking the beginning balance of the period, plus the ending balance of the period, and dividing it by 2.
You can find your accounts receivable balance on the balance sheet for the respect periods.
An obvious question for anyone calculating the accounts receivable turnover ratio is, is my number a good number?
There are a couple ways to know whether it is acceptable or not.
Below is a snippet of some of the more common industries and their standard accounts receivable turnover ratio. Click on the CSIMarket study to get the full list.
You use the accounts receivable turnover ratio to help improve cash flow. This is done by improving policies and procedures of your selling and collecting activities. Remember, a car is only useful if you drive it. A ratio is only useful if you use it.
An example may help paint the picture.
You are in the technology industry. Your accounts receivable balance is very high and you are struggling with cash flow. You have calculated your accounts receivable turnover ratio for the past 3 years and notice the ratio dropping from 13 to a low of 8 in the current year.
At this point you are concerned because industry standard for the accounts receivable turnover ratio is 14.42 and you are currently at an 8.
However, recent training with the accounts receivable turnover ratio taught you to ask questions and dig into the numbers.
Knowing that the ratio includes “net credit sales” and “average receivables” you start looking into those specific numbers knowing if you reduce accounts receivable or increase net sales the ratio will improve.
For starters you look at the accounts receivable aging and find more than half of your invoices are older than 90 days. Second you look at the sales only to discover your sales reps are extending credit to everyone in an effort to hit their sales goals.
You quickly realize you don’t have a collection procedure in place because you lack an accounting person and you as the owner are too busy to follow-up on past due accounts.
So, you take action and assign collections to one of your assistants and set up a procedure for them to send reminders and past due notices to encourage payment. In addition, you decide to implement an early payment discount for customers willing to pay early.
As for the credit sales, you implement a credit policy which requires verifying customer credit worthiness and training your sales reps on how to collect and verify this information. In addition, you change your commission policy to only paying commission on paid invoices.
All of these solutions result in reducing your average accounts receivable balance and thus increasing your ratio.
Each solution was the result of monitoring the accounts receivable turnover ratio and recognizing an issue. But the most important step was taking initiative to dig deeper and identify the real problems.
Ratios don’t solve problems, rather they highlight potential problems giving managers the opportunity to solve problems. The only way ratios work is if you prepare them, monitor them, and compare them.