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There are many metrics you can use to ascertain the overall viability of your business enterprise. The Accounts Receivable Turnover Ratio is one such formula and can be used to see how well a business handles collections and its cash flow.
If a business does not handle collections well, then cash flow management is an issue, meaning it could run into liquidity problems
This guide will give you everything you need in relation to the Accounts Receivable Turnover Ratio, including what it is, how to calculate it, and what its limitations are.
What Is the Accounts Receivable Turnover Ratio?
So, what is the account receivable turnover ratio so important, and why is it so important? In a nutshell, the ratio is a measure of how quickly a client pays a company. The accounts receivable is the total money owed to a business. The turnover ratio is the ratio of accounts receivable that is ‘turned over’ or paid in full. A higher ratio is generally considered better, as it indicates superior cash flow management. But this is not always the case, for various reasons outlined in the limitations section below.
Consider the difference between these two businesses. The first business allows customers to pay 30 days after the product/service has been rendered (as happens in some industries, especially wholesaling and manufacturing). In this instance, some pay on time, some will pay late, and some will never pay. This means that the company will not collect on all of its sales.
In contrast, a second business that bills in advance of the supply or service is guaranteed to collect on all invoices due.
The turnover ratio is given over a specific period, such as 90 days. This means a business might have a high short-term ratio and a low long-term ratio, and vice versa.
Accounts Receivable Turnover Ratio Formula
The AR Turnover Ratio is calculated by dividing net sales by average account receivables. Net sales is calculated as
|Sales Allowances – Sales On Credit – Sales Returns = Net Sales|
Average accounts receivables are calculated as the sum of starting and ending receivables over a set period of time (generally monthly, quarterly or annually), divided by two.
The formula for calculating the AR turnover rate for a one-year period is as follows
|Net Annual Credit Sales / Average Accounts Receivables = Accounts Receivables Turnover Ratio|
Calculating the Accounts Receivable Turnover Ratio Step by Step
So, how do you calculate the Accounts Receivable Turnover Ratio, step by step? It’s not the most difficult of calculations. We’ve broken it down into 3 primary steps below to make it easier.
#1 – Calculate Net Credit Scales
You can simply take this figure from your balance sheet or annual income statement. A table is given below with the place you can find your business net credit sales, located on the top two rows under Revenue:
Net Income Before Tax
#2 – Calculate Average Accounts Receivable
Not that you have gotten your net credit sales from either the balance sheet or the income statement, it’s time to calculate the average accounts receivable. This is simply the amount of money owed to your business by your creditors. The calculation is quite straightforward. Simply take the accounts receivable at the start of the year and add it to the accounts receivable by the end of the year. Divide the total by two to get the average accounts receivable for a given year.
#3 – Apply the Formula
Now that you have the net credit sales as well as the average accounts receivable, you can simply apply the formula mentioned above. Divide the net credit sales by the average accounts receivable to get your Accounts Receivable Turnover Ratio.
Intricacies of the Accounts Receivable Turnover Ratio
It all sounds quite simple. The higher your ratio, the better your cash flow management as a company, right? Not really. The ratio only applies to accounts receivable, which means goods sold on credit. If 95% of your sales on cash and you have a poor ratio, this is still preferable to a business that operates on 95% sales on credit with an excellent ratio. So you will need to take the proportion of cash to credit sales into account for the metric to be truly meaningful.
Secondly, if your ratio is too high, then there could be some problems. It might mean you are too aggressive in terms of who you do business with. You may only do business with customers that have an excellent credit history, and be missing out on potential sales opportunities. Further, some of your clients might be upset. That said, a higher ratio is generally better, for the following reasons:
- You receive payment for debts quickly. This increases your cash flow and allows you to pay your business’s debts more rapidly
- Your collections methods are effective
- You have high-quality customers that can continually purchase products and services
- You’re extending credit to the right kinds of customers, meaning you don’t take on as much bad debt. This is a prime sign of a financially healthy business
- Your customers are paying off debt quickly. This frees up credit lines for future purchases
The Accounts Receivable Turnover Ratio can tell you how long it takes a customer to pay their debt, on average. And the quicker this is paid, the better. But there are nuances. You can expect that more expensive items will take longer to get paid than cheap ones. And in certain industries, the average will simply be longer or shorter due to the nature of the businesses in question. You need to find out your industry average and beat it. If you allow customers 30 days to pay invoices and your average collection time is 50 days, then there is certainly a problem with your collections process.
How To Increase Accounts Receivable Turnover – 7 Pro Tips
Practically all businesses are looking for ways to improve their ratio, as it frees up cash flow and prevents liquidity crises. Lack of liquidity has sunk many otherwise solid business enterprises. The following are 7 of the best ways to increase the Accounts Receivable Turnover Ratio. Some of them might be basic, but they work really well.
#1 – Go Cash
Cash is still king, despite what all the advice might tell you. As much as possible, eliminate credit sales and accept cash and instant payment. Consider if your customers really need all that time to pay for things on credit. You might also want to change up your business model a little. Obviously, people need to pay for certain items on credit, particularly in manufacturing and other industries, especially for expensive items. But it’s still a risk, and it is best limited as much as possible.
Cash does not simply mean physical cash. Online payments are easy to make, and there are literally hundreds of ways to make payments online nowadays. Email-based payments, PayPal, cryptocurrency, online bank transfers, transfers through online applications – the methods of online payments are too many to enumerate upon. Get creative in terms of how you accept payment, and your customers will have no excuse for their tardiness.
#2 – Tighten Up on Credit Requirements
It can be tempting to accept all clients that want to purchase your product or service. But the fact is that if your clients are not paying you the money, then you are losing out big time. Not only are you losing money directly on supplying the product/service. You wasted a lot of resources marketing and finding customers who do not pay. Next, you wasted money trying to collect money from a non-paying customer.
If you have a high percentage of non-paying customers, then it is time to tighten up on credit requirements and who you do business with. Generally, customers with low credit are not worth it. The credit score system is designed to assess how well a customer can repay his or her debts. If the credit score is low, then the chances of repayment are low. Don’t offer credit to customers who are not creditworthy!
#3 – Have an Organized Invoicing System in Place
If you are sloppy with your invoicing, how do you expect your customers to be professional in their payments? As quickly as possible after a service has been provided, you should generate an invoice. If you leave it until a month later, the customer will have moved on. It’s better to invoice more frequently so that you are on the customer’s mind. Don’t wait until an invoice has built up to a certain amount.
This will increase the chances of losing out on a bigger sum. If a customer has missed two invoices, don’t give him or her a third until the most recent one has been paid. An accurate, detailed bill is the easiest kind of bill for your clients to pay! But it’s equally important that you bill on time, and bill often. Companies that invoice late risk setting a precedent for accepting late payments.
#4 – Have Clear Repayment Terms
Your invoice should have clear repayment terms. It should definitely include the time period that the customer has to pay the invoice. This is typically NET 30 or NET 60, meaning the customer has either 30 or 60 days to make payment. Opt for NET 30, as you can receive the payment quicker. If you are selling high-value items, you could also offer a repayment schedule to them.
It’s definitely a good idea to install a late payment penalty. This should not be huge, but enough to compensate you for the late payment and to get the customer to pay on time. These are often a percentage of the original invoice. Consequently, you may also consider an incentive for early payment, with the price steadily increasing the later the debt is paid.
#5 – Simplify the Billing Structure With Fixed Fees
The easier you make it for clients to pay the bills, the better they will pay them! The best way is to have a fixed monthly arrangement where the bill is paid automatically from a customer account such as a bank account. This way, the customer will rarely pay late unless the account runs out of money. You can receive fixed payments every month like clockwork.
Transitioning to a fixed fee structure is becoming more popular than ever, as it eliminates the hassle of claiming accounts receivable. Unless you are willing to have a very strong and thorough credit department to collect payment and vet each client, then it’s a better bet to make the transition. Unless you are aggressive with credit, the tendency is for late or non-payments, which means your cash flow will suffer.
#6 – Frequent Reconciliation
Bank reconciliation is often seen in online marketing platforms, but few really know what it is. A reconciliation is essentially the balancing of accounts. The more often it is done, the better, as it will mean your accounts are more up to date. The minute that you receive payments from credit customers, they should be reconciled to outstanding invoices and cleared off your receivables list.
This helps keep your accounts receivable balance current and makes it easier to track turnover. And helping to track turnover will result in an increased ability to spot trends in accounts receivable and cash flow, as the two lead into each other.
#7 – Use Online Accounting Software
There are a plethora of options when it comes to online accounting software. The best options include Quickbooks Online, Xero, and Patriot, but there are dozens more. Check out our definitive guide for a full list of online accounting software platforms.
These tools will connect with a host of analytical software making integration a whole lot easier. Many of them offer superb invoicing functionality with customized payment templates. As online accounting tools, they will calculate your Accounts Receivable Turnover Ratio for you, as well as many other important business metrics. Invoices can be automated and you can set alerts for late payments.
Using a secure online accounting solution is one of the best things you can do to improve your turnover ratio. It allows for accurate financial analysis and forecasting, helping to identify problem areas and clients that are not paying on time.
Limitations of the Accounts Receivables Turnover Ratio
The Accounts Receivable Turnover Ratio is a very useful tool, but it does have a number of limitations. As previously noted, it is not as relevant for businesses that deal mainly in cash. The following are the primary concerns and limitations with this ratio:
- Impediment To Sales – A very high ratio means that businesses will find it hard to attract customers in a market downturn. It can also mean that it will be hard to attract customers in general. If you look for customers with a 700+ credit score, then you are eliminating the majority of the market, meaning you are going to sell a lot fewer goods
- Volatile Average Ratio – The ‘average’ Accounts Receivable Turnover Ratio can be misleading. It is taken as an average throughout the year but might be excessively high/low in the beginning, middle, or end. However, this limitation can be offset by looking at the Accounts Receivable Aging metric
- Varies Per Industry – Not really a ‘limitation’ as such, but it should be noted that there is a vastly different average depending on the industry you are in. Some industry averages will be very high, others are very low. As previously mentioned, find your industry average and beat it
- Irrelevant to Cash-Based Businesses – If the majority of your businesses is based on immediate sales, then a low or high ratio will simply not be as relevant. If your businesses are mainly based on credit, then it becomes incredibly relevant
- It’s An Average – There is always a range. So the likelihood is that you have ~5% of customers who are not paying and are causing all of the problems. Averages are generally useful, but you need to set up an alert system to spot the worst offenders. You can do this even if you have a high ratio, as there are always a small slice of people responsible for the majority of issues. Statistics can be misleading, especially average ones
The Accounts Receivable Turnover Ratio is perfect for identifying how well a given business handles its cash flow and how quickly customers pay back their debts, on average. It shows how efficient the collections department really is and is a strong indicator of fiscal management.
For businesses that accept payments in 30 days, 60 days, or quarterly repayments, then this metric is essential. You simply can’t run a credit-based business without taking it into account and optimizing it as much as possible.
Because profitable businesses manage debts well, and unprofitable ones select the wrong customers and have inefficiency collection processes.