When a company doesn’t collect customer payments right away, it essentially provides a short-term loan or credit, which is recorded as an account receivable.
Say a company extends net 30 payment terms, then the customer has 30 days from receiving the invoice to pay the balance.
In an ideal world, businesses work with reliable customers who always pay on time — and maybe even before the payment is due. But, in reality, this isn’t always the case.
Late and overdue payments are frustrating to deal with and may even lead to cash flow issues for the company if it relies on the funds to cover its obligations.
To monitor its credit collection processes, companies can track the accounts receivable turnover ratio. As we’ll discuss in further detail below, this metric provides important insights into the efficiency of their collection operations and the quality of their customers.
In this guide, we’ll cover the accounts receivable turnover ratio in further detail, including what it means for businesses, how to calculate it, and strategies to improve it for better cash flow management.
What is accounts receivable turnover?
Accounts receivable (AR) turnover measures how many times in a given period a company turns its receivables into cash. This value may also be referred to as the AR turnover ratio.
While not reported on the company’s income statement, balance sheet, or other financial statement, AR turnover is a metric used internally to help companies understand how well they collect outstanding customer balances.
In other words, a low ratio might indicate that the company is inefficient at collecting receivables, which may lead to cash flow problems. A high ratio might illustrate that it effectively manages outstanding balances and customers pay invoices quickly, supporting healthy cash flows.
When is the accounts receivable turnover ratio used?
The AR turnover ratio is commonly used to compare companies within a similar industry. It has important implications for a company’s cash flow health and overall business operations, showing how well it can collect receivables from clients.
Potential investors might find this value important, as they want to see that a company has effective processes in place to collect the cash it has earned as income. This value can also provide insights into the quality and creditworthiness of the company’s customers, as those who are financially viable are more likely to pay their outstanding balances quickly.
Thus, businesses should regularly track and monitor this value to assess their collection practices. This allows them to compare themselves against competitors and determine how well they meet industry standards.
In this way, the AR turnover rate can drive important business decisions. It could showcase the business’s inefficiencies, leading them to shorten the payment terms they extend to customers or implement additional follow-ups and overdue payment reminders to hopefully collect payments more quickly.
How to calculate accounts receivable turnover?
Formula for accounts receivable turnover
The formula for the accounts receivable turnover ratio is as follows:
It shows the relationship between a company’s net credit sales and its average accounts receivables.
Thus, in order to use the AR ratio formula, organizations must prepare a few additional calculations beforehand. These aren’t values that you can simply find as a line item on the business’s financial statements.
Here’s a quick overview of these two formula components:
Net credit sales
As the name might suggest, net credit sales are the sales a company earns that are paid with credit. It can be calculated with the following simple formula:
Any sales paid with cash are not relevant to the AR turnover formula, as they don’t impact accounts receivable.
Average accounts receivable
A company’s average accounts receivable can be found using the starting and ending balance for the account during a given period.
Here is the formula you can use to find this value:
When calculating the AR turnover ratio, make sure to use values from the same period to find the average AR balance and net credit sales. Otherwise, the calculations could be misleading.
Examples of accounts receivable turnover
Putting the formula to work, here’s an example of how a lumber yard might calculate its accounts receivable turnover ratio.
For a given year, the business reported the following financial data:
- Net credit sales: $1,500,000
- Beginning accounts receivable: $95,000
- Ending accounts receivable: $140,000
First, the company needs to calculate the average AR balance, which would look like:
Average AR = ($95,000 + $140,000) / 2
Average AR = $235,000 / 2
Average AR = $117,500
Then, the business has all the necessary information to plug into the AR turnover ratio formula. Here’s what the calculation looks like:
AR Turnover Ratio = $1,500,000 / $117,500
AR Turnover Ratio = 12.8
What do we gather from this data? The lumber yard collects its receivables a little more than 12 times a year – or roughly once a month.
Over time, the business could track its AR turnover to ensure it continues to collect payments effectively or even improves its efficiency.
What is a good accounts receivable turnover?
There is no magic value that’s considered a “good” accounts receivable turnover ratio. An optimal AR turnover ratio can vary significantly depending on the industry, company size, and growth stage.
By nature, some industries have slower sales cycles and longer payment periods, like construction or manufacturing. Others, like retail or software-as-a-service (SaaS) companies, can expect quicker payments and higher turnover.
Across industries, the general idea is that the higher the ratio, the better. Again, this typically means that a good portion of customers are paying invoices on time, and fewer have outstanding and overdue balances.
Limitations of AR turnover ratio
The AR turnover ratio is a helpful metric for determining how well a company collects its credit sales, but there are certain limitations.
For instance, you may not know exactly how another business calculates its turnover ratio. While there is a generally accepted formula, as described above, certain companies may use total sales instead of net credit sales in the calculation, skewing the value higher.
Thus, when comparing a company’s ratio against competitors, this discrepancy is something to keep in mind.
Additionally, companies in seasonal industries may experience large fluctuations in accounts receivable activity throughout the year. Depending on the values chosen for the average accounts receivable calculation, the ratio may not accurately represent the business’s financial performance.
How to improve your business's AR turnover ratio
Businesses with a low AR turnover ratio compared to industry standards may be curious about how to improve it.
Targeting underlying factors like the quality of customers and invoicing practices can help businesses improve the ratio, enhancing their attractiveness to potential investors and supporting healthier cash flows.
Here are some expert tips and strategies to get started:
Be diligent about invoicing
One clear way to improve the AR turnover ratio is to stay on top of invoicing.
Delayed invoices could lead to delayed payments, so set the right tone with customers by promptly sending an invoice as soon as the products or services have been delivered.
Support multiple payment methods
Customers are more likely to pay on time if you accommodate their preferred payment method.
Maybe a customer prefers to call over the phone to submit a payment, they want to drop off a paper check, or would prefer to use an online method.
Thus, accepting multiple payment methods can reduce customer friction, leading to quicker payments and a higher AR turnover.
Offer early payment discounts
Another way to encourage quick payments is to offer a discount for customers who pay early.
If the standard payment terms are net 30, consider offering a 2% discount to those who pay within 15 days instead.
Set the discount rate thoughtfully, as you don’t want to take measures that improve the AR turnover rate while taking a big hit to profitability.
Be more selective about extending credit
Companies looking to improve the AR turnover ratio could try a more conservative credit policy.
In other words, maybe they need to be more selective about whom they extend credit to. Companies may establish additional policies to help qualify customers, like running a credit check, requiring a personal guarantee, or only offering credit to longtime customers.
There is a delicate balance here. While a policy that's too conservative could turn away certain customers, it can also help companies avoid giving too much credit to those who aren’t able to pay.
Thus, teams need to determine whether they’re willing to sacrifice potential sales to improve the AR turnover ratio.
Improve AR turnover with an automated invoicing system
Improving the AR turnover ratio helps businesses ensure they’re competitive in the industry and collect invoice payments more efficiently.
However, manually preparing and sending invoices and managing follow-ups on overdue payments can be tedious and time-consuming.
Fortunately, leveraging automated tools and software, like BILL’s accounts receivable solution, can help teams streamline the process.
This way, businesses can automate invoices and reminders for recurring payments or schedule one-time invoices for a future date.
The result is better operational efficiency and faster payment collections, improving the company’s AR turnover.
Sign up for a free trial of BILL today to see how the platform can help simplify invoicing.
