Accounts Receivable Turnover Ratio: Definition, Formula And How To Calculate

Introduction

Efficient and timely collections are vital for maintaining a healthy cash flow and maintaining the success of your business operations. However, customers occasionally miss payments, or sales don’t convert into cash due to issues like inaccurate invoices or disputes. These challenges can lead to cash flow problems, ultimately affecting your financial stability.

One of the best ways to identify these inefficiencies is by calculating the accounts receivable (AR) turnover ratio. This metric helps businesses assess how efficiently their AR team is collecting payments. Want to learn how to calculate, analyze, and improve this critical accounting ratio? Read on to discover more.

What Is Accounts Receivable Turnover Ratio? 

The accounts receivable turnover ratio, also known as the receivable turnover ratio, measures how efficiently a business collects payments from its customers and indicates how often sales are converted into cash during a given accounting period. You can calculate it on a monthly, quarterly, or annual basis.

Accounts receivable (AR), basically are short-term, interest-free loans that a business extends to its customers. If your business closes a sale to your customers, you can offer a credit term of 30 or 60 days. It means, your customer has 30-60 days to pay for the goods delivered. The AR turnover ratio outlines how efficiently your business can collect the average receivables it has extended to customers. The ratio is a metric to determine the number of times your receivables have materialized over time. 

The Accounts Receivable Turnover Ratio Formula

To calculate the accounts receivable turnover ratio, you have to divide the net credit sales by the average accounts receivables. Net credit sales is the sales allowance deducted from sales return. Average AR is the sum of the receivables at the beginning and end of the period divided by two. 

The accounts receivable turnover formula has four components. 

• Net credit sales 

It refers to the total sales revenue made on credit and excludes any returns or allowances. It shows the total amount of sales that a business expects to collect, providing a basis to measure the efficiency of collection practices. 

• Average accounts receivable 

It refers to the average amount of AR in a given period. Average accounts receivable ensures a balanced and accurate view of the receivables rather than just a snapshot at one point.

• Accounts receivable turnover in days 

The accounts receivable turnover in days is a metric that shows the average number of days a business takes to collect its receivables. It gives insights into how efficient a business’s credit and collection processes are. A lower number of days means a business has robust collection strategies that improve cash flow and reduce bad debts. 

A higher number of days means your business takes longer to collect payments, highlighting ineffective credit policies or collection practices. 

Average AR is the sum of the receivables at the beginning and end of the period divided by two.

Steps To Calculate Accounts Receivable Turnover Ratio

To calculate the accounts receivable turnover ratio, you have to first find out the net credit sales (sales returns minus the sales allowances). Businesses usually calculate the accounts receivable turnover ratio at the end of the year. However, you may choose to do it on a monthly or quarterly basis. However, small businesses should consider calculating the metric at regular intervals to scale and gain new customers. 

• Step 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

• Step 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 = (Beginning AR + Ending AR) ÷ 2

• Step 3: Divide the net credit sales with the average AR

To find the accounts receivable turnover ratio, divide net credit sales by the average accounts receivable. Make sure that both the determinants belong to the same accounting period. 

• Step 3: Calculate the AR turnover in days 

To get more precise data, you can extend the calculation by considering the AR turnover in days. You can divide 365 by the AR turnover ratio to find out the AR turnover in days. 

AR turnover in days = 365 / Receivable turnover ratio

Calculation Example of Accounts Receivable Turnover Ratio

Let’s consider a numerical example to understand better how to compute the accounts receivable turnover ratio. Say an FMCG company named ZEA wants to determine its accounts receivable turnover ratio at the end of the accounting year. The numbers look like this: 

The first step is to calculate the net credit sales 

Net credit sales = Total sales−Sales returns−Sales allowances

Net credit sales = $1,500,000−$150,000−$50,000

Net credit sales = $1,300,000

The next step is to calculate the average accounts receivable 

Average Accounts Receivable = Beginning accounts receivable + Ending accounts receivable/2

Average AR = $150,000+$100,000/2 

Average AR = $125,000

Now, the final step is to determine the accounts receivable turnover ratio. 

Accounts receivable turnover = Net credit sales/ Average accounts receivable 

This AR turnover ratio indicates that the company collects its average receivables about 10.4 times a yearly. TheIt’s a higher ratio that highlights that the company is quite efficient in managing receivables. 

Now, the company may also decide to find out AR turnover in days for more precise data. 

AR turnover in days = 365 / Accounts receivable turnover ratio

AR turnover in days = 365 / 10.4 

AR turnover in days = 35.2 

This number means that, on average, ZEA takes around 35.2 days to collect its receivables, with a slightly higher collection period. 

When Is Accounts Receivable Turnover Ratio Used?

The AR Turnover Ratio is used to measure how efficiently a business collects payments from its customers. It’s particularly useful when comparing performance over different periods or against competitors with similar business models to identify trends, strengths, or weaknesses in collection strategies. Additionally, tracking this ratio regularly helps businesses assess the effectiveness of their credit and collection processes.

Why Is It Important to Calculate the AR Turnover Ratio?

The accounts receivable turnover ratio supports two crucial business purposes. First, it enables you to understand the speed you need to fast-track payments from customers, so you can effectively plan your future expenditures and investments. Second, the ratio helps determine your credit policies that support both your collection practices and customers’ financial viability and mitigate credit risks. 

Here are more reasons why calculating the AR turnover ratio is vital. 

• Better cash flow management

The AR turnover ratio indicates whether you are quickly collecting outstanding accounts receivables, which leads to better cash flow management and improved financial health.

• Improved financial health

The AR turnover ratio indicates if you are collecting its outstanding accounts receivables quickly. This leads to better cash flow management and improved financial health.

• Customer creditworthiness

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

• 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 collection process.

What Is a Good Accounts 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 have low debts, pointing to a tighter balance sheet, stronger creditworthiness, and a more balanced asset turnover.

However, a good accounts receivable turnover ratio depends on many factors. If you have tighter collection periods for customers, it can hurt sales as customers won’t be eager to close sales with too rigid credit terms. On the other hand, longer collection periods with extremely delayed payments will lead to cash flow problems. 

High Or Low AR Turnover Ratio - Which Is Better?

In general, a higher AR turnover ratio is generally considered a good sign for the business and shows that your business has an effective and robust collection process. It also means you can maintain a financially stable company with favorable credit terms that support cash flows. On the other hand, a lower ratio means your business is too liberal with collections and extending credit and may face cash flow issues in the long run. But there’s an exception to both the rules. 

High AR turnover ratio examples 

Infy Consulting, a B2B firm that collaborates with a small number of corporate clients and accepts direct payments from companies outside its partner network, has an AR turnover ratio of 10. This means the firm can collect its receivables in an average of 36.5 days, indicating a positive cash flow with higher operational efficiency. 

However, a higher AR turnover ratio indicates overly strict credit terms. This might restrict sales opportunities and reduce incoming cash flow as potential clients turn to competitors offering more flexible payment options.

Low AR turnover ratio example

Let’s say Mitchell & Co. is a local office paper supply company that serves various small businesses. Due to a smaller AR team that handles all processes at a time, they are unable to prioritize invoices on time and have lenient procedures for collections. Despite customers usually settling payments on time, the business, unfortunately has a low AR turnover ratio of 4. 

In the long run, this extended collection time will strain cash flows and make it challenging to cover operating expenses. However, a low AR turnover ratio is not always a bad sign. It also means that the business is still in the growth stage and would want to capture more sales ahead of its competitors or keep up with customer requirements during financial downturns with a reduced risk of having overdue accounts. 

How to Track Accounts Receivable Turnover Ratio

Tracking your AR turnover ratios should be a continuous process. If they drop to an extremely low digit, you need to tighten your credit policies with proactive collection strategies as soon as possible to facilitate faster customer payments. But if they become too high, you may need to make your credit policies less aggressive, which could otherwise unnecessarily impact your sales in the long run. 

Additionally, by knowing how fast your customers are paying their dues, you can plan your operating expenses or growth investments more strategically and have a better grip over future cash flows. 

Limitations of AR Turnover Ratio

Like any other accounting metric, the AR turnover ratio comes with certain inconsistencies and gaps.First, you can use the ratio only within the context of the industry. For instance, retail businesses usually have cash-heavy operations and faster collections. Contrastingly, manufacturers will have slower collections due to longer payment terms. So, it’s critical to be careful when grouping companies when applying the AR turnover ratio, ensuring you derive only meaningful insights. 

Additionally, the ratio only sheds light on the overall payment trends of customers. It won’t tell you if a business is heading for a financial crisis or paving opportunities for a competitive edge in the tougher economic times. It is also ineffective if you want to find out precise data about customers who settle dues on time. 

Lastly, if your business is subscription-based or cyclical, the AR turnover ratio may appear skewed throughout the accounting calculation. To determine whether or not you are getting an accurate ratio or not, compare it with an AR aging report that will categorize receivables by the time period of an outstanding invoice. 

Other Metrics to Consider Along with the AR Turnover Ratio

One of the ways to close the AR turnover ratio gaps is to consider other accounting metrics like collections effective index (CEI), day sales outstanding (DSO), and bad debts to sales ratio. This will help you better understand your business’s financial performance and combine the insights with that of the AR turnover ratio when reporting. 

• 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 gives a more comprehensive picture of the collections process and performance. A high turnover ratio with a low DSO suggests that your business has an efficient collection and credit policy. Contrarily, a low turnover ratio with a high DSO indicates that the company needs to optimize its collections and credit policy.

• 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 to sales ratio indicates the percentage of the bad debt affecting a company’s bottom line. If there’s an increase in bad debt, the company should reconsider its collections and credit policies. To calculate this ratio, divide uncollectible sales by annual sales and find the percentage. 

• Collection Effectiveness Index (CEI)

CEI provides insights into collections teams’ performance and how quickly accounts receivables turn into closed accounts. To calculate CEI, businesses need numbers for beginning receivables, monthly credit sales, and ending total and current receivables. The ideal CEI is said to be 100%, which indicates an efficient collection process. A decrease in CEI means you need to improve its collection strategy.

5 Tips to Improve AR Turnover Ratio with Automation

The key to a good accounts receivable turnover ratio is to focus on transforming credit and collections processes for proactive AR recovery. The best way to achieve this is to automate it with a robust accounts receivable software. Here’s how automation benefits accounts receivables, thereby positively impacting the AR turnover ratio. 

• Manage credit effectively

Before extending credit, evaluate the creditworthiness of customers by implementing a credit scoring system. Additionally, credit limits should be regularly reviewed and updated based on the customer’s payment history to mitigate credit risk effectively.

You can leverage features of the automated credit cloud that helps you create a daily work list of prioritized customer accounts for analysts to review, get nuanced insights on customers’ creditworthiness with out-of-the-box integration with 25+ credit agencies, and use AI Algorithms to predict upcoming blocked orders and suggest actions. 

• Send invoices on time

The first step to ensure faster payments is to have a streamlined invoice processing in place. Make sure you start preparing invoices right away after the goods are delivered and include all the necessary information. 

You can use EIPP (Electronic invoice payment and presentment) to automate sending invoices and account statements to customers. It not only serves as an end-to-end service portal for invoice tracking but also uploads invoices along with statements and attachments on customers’ AP portals. Additionally, you can automate invoice delivery via emails while easily tracking invoice delivery status and open rates. 

• Foster proactive collections

One of the major reasons for a low AR turnover ratio is that businesses prioritize collection efforts only when a customer has already failed to pay on the due date. Implement a proactive collection process to identify high-risk customers early on and adjust your strategy accordingly. Also, make sure to send timely payment reminders either through dunning emails or calls and track invoice status and payment patterns on their AP portals. 

The easiest way to do this is to use collections automation software that offers AI-driven email correspondence and templates to send payment reminders, transcribe customer interactions, note Promise-to-Pays over calls through in-app dialers, and resolve invoice disputes promptly. It will also log in automatically on AP portals and give detailed insights on customer behavior and invoice status. 

• Streamline cash application

Using automated cash application solutions offers numerous benefits, including the elimination of manual errors, ensuring precise posting of payments, and experiencing accelerated cash application. With AI-based cash application software, you will get seamless straight-through processing, reducing application time and ultimately enhancing your accounts receivable turnover ratio. 

• Less time to resolve deductions

Resolving invoice errors is another reason for delays in payments. To highlight inconsistencies or inaccuracies in invoices, a customer will raise deductions and ask you to validate the invoice. But most of the time, businesses take forever to match with reason codes, gather backup documentation, collaborate with relevant departments, and then communicate the invoice status with customers. 

The only way to streamline the deductions management process is to automate it. Using a deduction management system helps validate invoices using AI algorithms that can look up to over 20 variables, automate the aggregation of Deduction backup documents, identify auto-match with reasons using deductions auto coding, improving your net recovery by 30%.

Enhance Your AR Turnover Ratio with Order to Cash Software 

HighRadius offers powerful, cloud-based Order to Cash software to automate and streamline financial operations. This comprehensive suite includes Collections Management, Cash Application, Deductions Management, Electronic Invoicing, Credit Cloud, and dotOne Analytics to enhance your team’s efficiency and optimize its workflows.

• HighRadius’ AI-powered collections software prioritizes worklists for high-value customers and automates collections for the remaining accounts, leading to reduced past dues and increased collectivity
• With AI-driven data capture and matching algorithms, you can achieves 90% automation in same-day cash application, eliminating bank key-in fees entirely.
• You can also accelerate deduction research and resolution, enhancing analyst efficiency by 40% with our AI-powered deductions management software.
• HighRadius’ AI-based credit solution provides real-time credit visibility and global portfolio management.
• Additionally, you can enhance customer experience with a self-serve portal for buyers and multi-channel invoice delivery.
• Make informed decisions with visualized data and track operational KPIs advanced analytics

FAQs

How to improve receivable turnover?

Here are a few ways to improve the receivable turnover: 

• Effective credit management
• Send invoices on time
• Foster proactive collections
• Streamline cash application
• Ensure reduced time to solve deductions 
• Offer incentives for early payments 
• Offer flexible payment options
• Automate the collection process 

What causes accounts receivable turnover to decrease?

Here are a few reasons why accounts receivable turnover decreases: 

• Increased credit terms 
• Delayed invoicing and slower follow-up
• Customer credit issues, including poor creditworthiness
• Economic downturns and changing industry trends
• Lack of automation 
• Poor customer relationship management 

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?

Numerous factors affect AR turnover, such as credit policies, payment terms, collections process, industry practices, late payments, uncollectible accounts, and customer disputes. Clear payment terms, effective collections policies, and clear communication with customers can help you navigate these challenges.

Is high AR turnover good or bad?

In general, a high AR turnover ratio is a good sign and shows that your business has an effective and robust collection process. However, it also means that credit terms are too strict, which could impact cash flows during economic downturns, with customers shifting to businesses that offer favorable payment terms.

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.