For any enterprise or mid-sized business to flourish, cash is vital. If cash is the soul, accounts receivable turnover is the heart that pumps cash flow. Maintaining a steady cash flow is a constant requirement — therefore, collecting the dues is the crux of a stable cash flow requirement. The efficiency of a business’s accounts receivable is associated with its collections process. And for businesses to optimize collections and increase cash flow, business-essential metrics such as the accounts receivable turnover ratio play a significant role.
Accounts Receivable Turnover is a metric that estimates how effectively a business can convert its credit transactions to cash. It’s not as complex as it sounds. For example, you’re already familiar with bookkeeping and with that, it’s reasonably easy to monitor financial transactions and manage credits, but what’s essential in accounts receivable turnover is how quickly you collect your dues too. In short, you efficiently use your assets to drive revenue growth.
Businesses can derive insights and projections based on this ratio, which helps them plan their finances better.
Here’s a simple formula to calculate Accounts Receivable Turnover Ratio:
Let’s say, Laura, the CEO of Company A, offers credit sales to her customers, and the financial results for a year are:
Accounts Receivable Turnover Ratio = Net Credit Sales/Average Accounts Receivable
From the above calculation, we can conclude that company A has successfully collected accounts receivable eight times in a year. Now, it is also crucial to calculate the accounts receivable turnover in days.
A simple formula to calculate it is:
Receivable turnover in days = 365/AR turnover ratio
This means, an average customer takes nearly 46 days to repay the debt to company A. Now, if Company A has a strict 30-day payment policy, the accounts receivable turnover days show that on average, customers pay late.
A good accounts receivable turnover depends on how quickly a business recovers its dues or, in simple terms — how high or low the turnover ratio is. For instance, let’s talk about Company A’s payment policy itself. With a 30-day payment policy, if the customers take 46 days to pay back, the Accounts Receivable Turnover is low. But if the customers are paying back within the policy time, the ratio is high, thereby contributing to a good accounts receivable turnover.
A good accounts receivable turnover means that a business has a solid credit policy, an excellent due collection process, and a record of exceptional customers who pay their dues on time. We’ll understand this in depth in the following sections.
The accounts receivable turnover is used to analyze how effective a company’s revenue collection is, and that’s why it’s important. A high or a low receivable turnover tells us how quickly or slowly a company collects its receivables. We’ll explore these scenarios in detail:
An increase in accounts receivable turnover ratio indicates that a company is efficient in collecting cash and has promptly paying customers. It could also signify that a company has a pretty strict credit policy while offering sales on credit to its customers. A benefit of having a conservative credit policy is that businesses effectively avoid unnecessary loss of revenue by not extending credit to customers with poor credit history. On the other hand, a restrictive credit policy might drive away potential customers or limit business growth, negatively impacting sales.
A low accounts receivable 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 collection processes. It could also be due to lenient credit policies where the company is over-extending credit to customers with more risk of default.
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.
To gauge how effective an AR team is, you can analyze DSO along with the AR Turnover Ratio. AR turnover ratio of 10 implies that a company could collect its receivables 10 times in a specified period. Another variant of receivable turnover is the DSO, which calculates the average number of days it takes for a company to collect receivables after a sale. If the AR turnover ratio is 10, then a simple formula to calculate DSO is:
DSO = 365/ Receivables turnover
This shows, on average, a company has 36.5 days of outstanding receivables. Businesses can obtain an overall picture of its collections process and its performance if they compare AR turnover ratio and DSO together.
A high turnover ratio with low DSO means: a company has good collections and credit policy.
A low turnover ratio with high DSO means: a company must 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)
Similar to the AR turnover ratio and DSO, CEI is an essential metric for tracking accounts receivable. CEI offers a more accurate reflection of collections and credit performance with fluctuating sales. CEI can provide insights into collections teams’ performance and how quickly accounts receivables turn into closed accounts. Businesses should have the following information handy to calculate CEI.
Beginning receivables: Open receivables at the start of the month
Monthly credit sales: Total sales by extending credit for a month
Ending total receivables: Open receivables including current and overdue receivables
Ending current receivables: Only open receivables that are not overdue.
CEI= [(Beginning Receivables +Month’s Invoice Revenue–End Total Receivables)/(Beginning Receivables+Month’s Invoice Revenue–End Current Receivables)]x100
The ideal goal for CEI is 100%. Only then it means the company has an efficient collection process; a decrease in CEI signifies that the company has to improve its collection strategy.
Some businesses boast of an excellent AR turnover ratio, but it doesn’t mean there are no areas for continued development. For instance, excel-based calculators can help calculate AR turnover Ratio. With metrics like DSO on a monthly/quarterly/yearly basis, a business can detect when it’s about to hit a roadblock.
Let’s look at some valuable tips to improve the AR turnover:
Proactive Receivables Management: Businesses should establish policies for payment reminders and track customer payment behavior. Analysts should identify late-paying customers and proactively follow up before the aforementioned due date to avoid payment delays.
The business world today is competitive and complex. But, digital transformation largely contributes to an effective business strategy. With advanced and niche tools like Artificial Intelligence — businesses can automate collection processes. An automation tool can aid in setting up a methodical process for carrying out effective communication, raise invoices, send reminders, and analyze metrics to perpetually improve a business’s accounts receivable turnover ratio.
Ready to implement this in your business? You can improve collector’s efficiency, minimize bad debt write-offs and reduce DSO with HighRadius’ e-invoicing and automated collections solution.
Automate invoicing, collections, deduction, and credit risk management with our AI-powered AR suite and experience enhanced cash flow and lower DSO & bad debtTalk to our experts
HighRadius Autonomous Receivables Software Platform is the world’s only end-to-end accounts receivable software platform to lower DSO and bad-debt, automate cash posting, speed-up collections, and dispute resolution, and improve team productivity. It leverages RivanaTM Artificial Intelligence for Accounts Receivable to convert receivables faster and more effectively by using machine learning for accurate decision making across both credit and receivable processes and also enables suppliers to digitally connect with buyers via the radiusOneTM network, closing the loop from the supplier accounts receivable process to the buyer accounts payable process. Autonomous Receivables have been divided into 6 distinct applications: Credit Software, EIPP Software, Cash Application Software, Deductions Software, Collections Software, and ERP Payment Gateway – covering the entire gamut of credit-to-cash.