Accounts Receivable Turnover Ratio: How to Analyze and Improve It

Introduction

Businesses rely on a steady cash flow to operate smoothly, especially during times of economic uncertainty. One key aspect of managing cash flow is ensuring timely collection of dues. A simple and efficient method for tracking timely payments is through effective management of accounts receivable. By doing so, businesses can improve their cash flow management.

With that in mind, let’s learn how to calculate your accounts receivable turnover ratio and how to interpret it. We’ll also cover how to analyze and improve it, allowing you to mitigate the risk of a cash crunch. Let’s dig in.

What is Accounts Receivable Turnover Ratio?

The accounts receivable turnover ratio is a measure of how quickly a company can turn sales made on credit into cash. It’s an important number for any business because it shows how well the company is managing the money it’s owed.

Why Is It Crucial to Measure Accounts Receivable Turnover Ratio?

The importance of the accounts receivable turnover ratio cannot be overstated. It is a crucial metric that helps businesses optimize their cash flow management. Here are some reasons why the accounts receivable turnover ratio deserves your attention:

1. Better Cash Flow Management: It provides insights into how quickly a business can collect its outstanding accounts receivables. By monitoring this ratio regularly, businesses can identify trends, make better decisions, and optimize their cash flow.

2. Improved Financial Health: It indicates if a business is collecting its outstanding accounts receivables quickly. This leads to better cash flow management and improved financial health.

3. Customer Creditworthiness: It also helps businesses assess customer creditworthiness. By analyzing the ratio for individual customers, businesses can identify those who are slow to pay or may have difficulty paying.

4. Better Decision-Making: It provides valuable information that helps businesses make better decisions. By analyzing the ratio over time, businesses can identify trends and make adjustments to their collections process.

How to Calculate Accounts Receivable Turnover Ratio

The accounts receivable turnover ratio calculation is done by dividing net credit sales by the average accounts receivable. It helps measure a company’s effectiveness in collecting debts and managing customer credit.

Accounts receivable turnover formula

Accounts Receivable Turnover Ratio = Net Credit Sales / Average Accounts Receivable

Steps to calculate:

1. Calculate the net credit sales: Net credit sales are determined by deducting returns and allowances from the total gross sales. This calculation reflects the actual sales revenue that a company can expect to collect from credit sales.

   Net Sales Formula = Gross Sales – Refunds/Returns – Sales on Credit

2. Determine the average accounts receivable: Average accounts receivable is found by taking the sum of starting and ending receivables for a period and dividing by two, providing the average balance owed to the company during that time.

   Average Accounts Receivable Formula = (Beginning AR + Ending AR) ÷ 2

3. Divide the net credit sales: To find the accounts receivable turnover ratio, divide net credit sales by the average accounts receivable.

A Sample Calculation of Accounts Receivable Ratio

Let’s take an example to understand how to calculate the accounts receivable turnover ratio. Laura, the CEO of Company A, offers credit sales to her customers. In a year, the company had gross credit sales of $200,000, but there were returns of $20,000. The accounts receivable at the beginning of the year was $20,000, and at the end of the year, it was $25,000.

To calculate the accounts receivable turnover ratio, we need to divide the net credit sales by the average accounts receivable. The net credit sales would be the gross credit sales minus returns, which is $200,000 – $20,000 = $180,000. The average accounts receivable would be the sum of the beginning and ending accounts receivable divided by 2, which is ($20,000 + $25,000) / 2 = $22,500.

Therefore, the accounts receivable turnover ratio for Company A would be $180,000 / $22,500 = 8. This means that Company A was able to collect its accounts receivable eight times during the year.

It’s also important to calculate the accounts receivable turnover in days, which indicates how long it takes customers to repay their debt. To do this, we can use the formula: Receivable turnover in days = 365 / AR turnover ratio. So, for Company A, the accounts receivable turnover in days would be 365 / 8 = 45.63. This means that, on average, it takes customers nearly 46 days to repay their debt to Company A.

If Company A has a strict payment policy of 30 days, the accounts receivable turnover days indicate that customers are paying late. This would suggest that the company needs to improve its collection process or adjust its credit policy to ensure that customers pay on time.

Accounts Receivable Turnover Ratio Interpretation: What Does It Mean?

A high or a low AR turnover tells us how quickly or slowly a company collects its receivables. Let’s explore these scenarios in detail:

High AR Turnover Ratio:

A high AR turnover ratio indicates that a company is efficient in collecting cash and its customers are paying promptly. It suggests that the company’s collection process is effective, and they have a high-quality customer base. This could also be due to a conservative credit policy where the company avoids extending credit to customers with poor credit history to prevent unnecessary loss of revenue. However, a restrictive credit policy may limit business growth and negatively impact sales.

Low AR Turnover Ratio:

A low AR turnover ratio or a decrease in accounts receivable turnover ratio suggests that a company lacks efficient collection strategies to collect receivables on time. It indicates that customers are defaulting, and the company needs to optimize its collection process. This could be due to lenient credit policies where the company is over-extending credit to customers with a higher risk of default. It’s crucial to address the issue promptly to avoid cash flow problems and maintain healthy finances.

What is an Ideal Receivable Turnover Ratio?

An ideal accounts receivable turnover ratio shows good cash flow management. In general, a higher number indicates that customers are paying on time and debt is being collected efficiently, pointing to a tighter balance sheet, stronger creditworthiness, and a more balanced asset turnover.

However, what is considered a good number for the accounts receivable turnover ratio varies by industry and company-specific circumstances. To achieve a good ratio, businesses should establish an efficient collection process, implement strict credit policies, and maintain a record of reliable customers. By doing so, they can improve their cash flow, reduce the risk of delinquent accounts, and optimize their financial performance.

List of Different Industry Average Accounts Receivable Turnover Ratio

As per CSIMarket’s data for Q3 2023, the average accounts receivable turnover ratio by industry is as follows:

What Other Metrics Should Be Analyzed Along with the AR Turnover Ratio?

The accounts receivable turnover ratio is an important metric — but it’s still hypothetical and leaves room for assumptions. While this metric could state that a company’s credit policy might be too lax or conservative, it doesn’t elaborate the ‘why’ behind the numbers. To understand a company’s financial health better, AR managers should analyze the accounts receivable turnover ratio along with a few other parameters.

Days Sales Outstanding (DSO)

DSO calculates the average number of days it takes for a company to collect receivables after a sale. It's calculated by dividing 365 by the receivables turnover ratio. If the turnover ratio is 10, the DSO would be 36.5, indicating that the company has 36.5 days of outstanding receivables.

Analyzing DSO along with the AR turnover ratio can provide a more comprehensive picture of a company's collections process and performance. A high turnover ratio with low DSO suggests that the company has an efficient collections and credit policy. On the other hand, a low turnover ratio with high DSO indicates that the company needs to optimize its collections and credit policy.

Bad Debt to Sales Ratio

Another important metric that AR managers should monitor is the Bad Debt to Sales Ratio. Bad debt is the amount written off by a business when customers cannot pay the debt back. The bad debt ratio indicates the percentage of the bad debt affecting a company’s bottom line. A simple formula to calculate the ratio is:

Bad Debt Ratio = (Uncollectible sales/Annual Sales) x 100

If there’s an increase in bad debt, the company should reconsider its collections and credit policies.

Collection Effectiveness Index (CEI)

CEI is an essential metric for tracking accounts receivable and offers a more accurate reflection of collections and credit performance with fluctuating sales. CEI provides insights into collections teams' performance and how quickly accounts receivables turn into closed accounts. To calculate CEI, businesses need to have information on beginning receivables, monthly credit sales, ending total and current receivables. The ideal goal for CEI is 100%, indicating an efficient collection process. A decrease in CEI signifies that the company needs to improve its collection strategy.

CEI = [(Beginning Receivables +Month’s Invoice Revenue–End Total Receivables)/(Beginning Receivables+Month’s Invoice Revenue–End Current Receivables)]x100

How to Improve Your Accounts Receivable Turnover Ratio?

Now that you understand the importance of calculating your AR turnover ratio and how to calculate it, let's explore how to enhance it to maximize your cash flow. To improve this ratio, it is essential to focus on the various sub-functions within your order-to-cash process. Let's delve into some valuable tips for improving your AR turnover:

Manage credit effectively:

Before extending credit, evaluate the creditworthiness of customers by implementing a credit scoring system. Additionally, regularly review and update credit limits based on the customer's payment history to effectively mitigate credit risk.

Send invoices on time:

To encourage prompt payment, it is crucial to ensure that the payment due date is clearly stated on your invoices. This provides clarity to your clients and helps them make payments on time. Additionally, offering multiple payment options such as checks, e-payments, and ACH, and including payment links in dunning emails, simplifies the payment process for customers. Moreover, sending timely reminders serves as an effective strategy to prompt timely payments.

Collect proactively:

By implementing a proactive collection process, businesses can identify at-risk customers and prioritize reaching out to them. This approach helps minimize the occurrence of delinquent accounts and safeguards against accumulating bad debt. 

Through active management of collections, businesses can optimize cash flow, providing customers with a seamless and reliable payment experience while maintaining a solid foundation of financial stability.

Opt for an Automated Billing Solution

It's no secret that automation and AI are revolutionizing businesses, improving performance, reducing errors, and enhancing quality and speed. If your account receivable process is not leveraging automation, it's time to consider the transformative potential. According to a global survey conducted by Sterling Commerce, implementing automation in accounts receivable departments can yield remarkable cost savings of up to 44%.

By embracing automated cash application solutions, your business can unlock a multitude of benefits, including the elimination of manual errors, ensuring precise posting of payments, and experiencing accelerated cash application.

Additionally, harnessing the power of AI-based cash application software enables seamless straight-through processing, reducing application time and ultimately enhancing your accounts receivable turnover ratio. Embrace automation to maximize efficiency and optimize your financial operations.

Reduce deductions:

Streamline your collections process and optimize financial performance by leveraging a deduction management system. By implementing a deduction management system, businesses gain the advantage of swiftly identifying and resolving disputes, resulting in shorter collection cycles. Also, by proactively analyzing deduction trends and collaborating with customers, businesses can minimize deductions.

Give incentives for early payments:

Providing early payment discounts can incentivize customers to pay their dues faster. For instance, offering a 2% discount if customers pay within 10 days can encourage prompt payments. Alternatively, businesses can provide more significant discounts to customers who pay upfront, such as at the time of product/service delivery or before it.

In today’s fast-paced business environment, companies need to be agile and efficient to stay competitive. Manual processes can be a significant roadblock to optimizing your accounts receivable turnover ratio and driving cash flow. It’s time to embrace automation and leverage the transformative potential of technology to streamline your order-to-cash process and improve your financial operations.

By automating tasks such as invoice delivery, payment posting, and collections, you can reduce errors, enhance accuracy, and accelerate cash application. With the right tools, you can unlock a multitude of benefits that will help you achieve your financial goals.

If you want to delve deeper into the impact of deductions on financial performance and understand how industry giants manage this aspect, explore our blog that compares Amazon and Walmart on DSO, DPO, Cash Conversion Cycle, and more.

How Can HighRadius Help Improve Your Accounts Receivable Turnover Ratio?

If you’re looking to improve your accounts receivable turnover ratio, HighRadius’ Autonomous Receivables suite of solutions can help. This suite of solutions automates all aspects of your accounts receivables process, from invoice delivery and tracking to collections worklist prioritization, payment predictions, and cash projections.

HighRadius offers cloud-based Autonomous Software for the Office of the CFO, which brings modern digital transformation capabilities like artificial intelligence, robotic process automation, natural language processing, and connected workspaces as out-of-the-box features for the finance & accounting domain.

So if you’re ready to streamline your AR processes and improve your cash flow, schedule a demo with HighRadius today to understand how our solutions work and how we can help your business.

FAQs on Accounts Receivable Turnover

What is a good accounts receivable turnover ratio?

A good accounts receivable turnover ratio varies by industry, but in general, a higher ratio is better as it indicates efficient collections. A ratio of 7.8 is considered good on average. Monitoring and analyzing the ratio helps businesses gauge their financial health and spot areas to improve.

What affects receivables turnover?

The accounts receivable turnover can be affected by factors such as credit policies, payment terms, collections process, industry practices, late payments, uncollectible accounts, and customer disputes. To minimize these impacts, businesses should establish clear payment terms, develop effective collections policies, and maintain regular communication with customers.

Is high AR turnover good or bad?

High AR turnover is generally positive, reflecting prompt customer payments and healthy cash flow. However, excessively high turnover may suggest lost sales due to strict credit policies. Balancing turnover to optimize sales and minimize risk is ideal.

What does accounts receivable turnover tell you?

The accounts receivable turnover ratio measures how often a business collects its accounts receivable and indicates the efficiency of credit and collection policies. High turnover means quick collections, while low turnover points to slower collections or potential credit issues with customers.

How to find accounts receivable turnover?

To find the accounts receivable turnover, divide net credit sales by the average accounts receivable balance. Net credit sales can be found on the income statement, and the average A/R balance can be calculated by adding the beginning and ending A/R balances for a period and dividing by 2.