Accounts Receivable Turnover Ratio and How to Use It for Optimizing Accounts Receivables

What is Accounts Receivable Turnover Ratio?

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.

How Do You Calculate Accounts Receivable Turnover Ratio?

Here’s a simple formula to calculate Accounts Receivable Turnover Ratio:

Here

• Net Credit Sales is the cash collected from sales.
  Formula to calculate Net Credit Sales = Sales on credit – Sales returns – Sales allowances.
• Average Accounts Receivable is the sum of the first and last accounts receivable over a monthly or quarterly period, divided by 2.

A Sample Calculation of Accounts Receivable Ratio

Let’s say, Laura, the CEO of Company A, offers credit sales to her customers, and the financial results for a year are:

• Gross credit sales = $200,000 with returns = $20,000
• Accounts receivable of $20,000 at the beginning of the year
• Accounts receivable of $25,000 at the end of the year

Therefore,

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

= [$200,000-$20,000]/[($20,000+$25,000)/2]

= $180,000/$22,500

= 8

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

= 365/8

= 45.63

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.

• What is a Good Accounts Receivable Turnover?

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 Importance of AR Turnover Ratio: What Does the Receivable Turnover Ratio Tell Us?

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:

• High Accounts Receivable Turnover Ratio

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.

• Low Accounts Receivable Turnover Ratio

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.

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)

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

= 365/10

=36.5

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.

Tips to Improve Accounts Receivable Turnover

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:

• Establish clear payment terms: Businesses must communicate payment terms on contracts and invoices to avoid payment delays. Further, businesses can offer discounts to customers who pay early and proactively inform them about the importance and benefits of timely payments as it improves accounts receivables.

• Develop customer satisfaction: Satisfied customers will likely pay on time. For that, it’s best to maintain clear and precise communication and professionally over email. Avoid ad-hoc, unnecessary correspondence and ensure that customers can access their invoices and account statements without hassle. This can foster a great customer experience and have a positive impact on receivables.

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.

How Automation Can Help

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.