The Accounts Receivable Turnover Ratio is a financial metric that measures the efficiency of a business in collecting payments from customers. It serves as an essential tool for businesses to evaluate their credit and collection policies and identify areas for business growth.
In this article, we will help you explore the definition and formula of the Accounts Receivable Turnover Ratio, its importance, and how to calculate and improve it.
What Is the Accounts Receivable Turnover Ratio?
The accounts receivable turnover (ART) ratio is a calculation that measures the average frequency a company collects its accounts receivable balance during a specific period, typically a year. It indicates how tactical the business is at chasing payments, focusing on extending customers’ credits.
Accounts Receivable itself refers to the amount of money customers owe to the company for purchases of goods or services based on credit. It is a crucial metric for businesses that rely on credit sales and need to manage their working capital.
Accounts Receivable Turnover Ratio Formula
The formula for calculating the accounts receivable turnover ratio is:
|Accounts Receivable Turnover Ratio = Net Credit Sales / Average Accounts Receivable|
- Net Credit Sales refer to the total credit sales made during a given period.
- Average Accounts Receivable is the amount of money owed to a company by its customers during that same period on average.
To calculate Net Credit Sales, subtract the total returns and allowances from the total credit sales. Returns and allowances are the amount of refund customers receive for the returns of goods or services due to certain reasons.
|Net Sales = Gross Sales – Refunds – Sales on Credit|
To determine the average collection period, add the beginning and ending accounts receivable balances for a given period then divide by two. Alternatively, take the sum of the accounts balance at the end of each month and divide it by the number of months in the allocated period.
|Average Accounts Receivable = (Beginning Accounts Receivable + Ending Accounts Receivable) / 2|
Let’s take an example,
Suppose Company ABC wants to calculate its Accounts Receivable Turnover ratio for the year 2022. The net credit sales are $1,000,000, with beginning Accounts Receivable at $50,000 and ending Accounts Receivable is $70,000. First, Average Accounts Receivable = (50,000 + 70,000)/2 = 60,000.
Therefore, the Accounts Receivable Turnover ratio = 1,000,000 / 60,000 ≈ 16.67
This means the Accounts Receivable Turnover ratio for Company XYZ for the year 2022 is approximately 16.67.
Accounts Receivable Turnover Formula in Days
Another way to estimate the accounts receivable turnover ratio is in days. This version of the formula is known as the Debtors Turnover Ratio Formula in Days or the Accounts Receivable Days Formula, which measures the average number of days it takes for a business to collect payment from its customers.
|Accounts Receivable Turnover Ratio in Days = 365 / Accounts Receivable Turnover Ratio|
For instance, if a company’s Accounts Receivable Turnover Ratio is 10, its Accounts Receivable Turnover Ratio in Days would be 36.5 days (365 / 10).
Accounts Receivable Turnover Ratio Interpretation
A good accounts receivable turnover ratio depends on the industry and the nature of the business.
Generally, a high accounts receivable turnover ratio is desirable as it indicates that the company has an efficient payment collection and credit strategy. This lowers the risk of bad debts, thus maintaining a healthy cash flow.
If the ratio is too high, however, implies that the business has a strict credit and collections policy and they’re losing customers along the way.
For investors and creditors, the accounts receivable turnover ratio provides insights into the business’s financial health and potential for scalability. A high ratio means the business is conservative about managing financial assets.
A low accounts receivable turnover ratio suggests that the business is struggling to make ends meet with collecting customer payments, which can harm the business’s financial health due to the lowering of operational funds.
It is important to note that a low ratio is not always a red flag. In certain business fields, it is normal to have a longer collection process as it’s in the nature of their products or services.
This is why companies have compared the average in the industry before defining a healthy rate of their AR Turnover. Competitors’ research can also go a long way in figuring out the areas for improvement and the most ideal approaches to scaling the business.
Industry Average Accounts Receivable Turnover Ratio
|ART Ratio Ranking by Industry||Ratio|
In the short and continuous term, having a high ART Ratio ensures the efficiency of the business’s working capital cycle. In the long term, it plays a key role in securing investors to fund the businesses and preserve the lifecycle of the company.
Importance of Accounts Receivable Turnover Ratio
It is highly important for businesses of any size to stay on top of these accounts receivable metrics.
Here are the key reasons why the accounts receivable turnover ratio is important:
Cash Flow Management
The ART Ratio gives transparency into how quickly and effectively the collection strategy of a company is. For any business, cash is king, and a good collection strategy will benefit the overall cash flow of the company.
Offering credit to customers at a glance can be risky as it exposes the business to the risk of bad debts. However, if a business has a high ART Ratio, it means that they are successful in streamlining credit and AR management, therefore bringing more profit to the company.
Internally, the accounts receivable turnover ratio can be an assessment to improve the practical methods of collecting customer payments. Externally, it is concrete proof that can persuade investors and creditors to provide access to wider monetization channels and lower borrowing costs.
Strategic Decision Making
The accounts receivable turnover ratio functions as a financial database upon which the company can make more sound decisions about where it should invest its money for growth.
How to Improve Accounts Receivable Turnover
Now that you understand the many perks of having a high Turnover Rate for Accounts Receivable, here are some ways your business can do to reduce the collection cycle:
Tighten credit policies
Your business should be stricter and tighter in establishing credit regulations, especially for late payers, and strategize collections accordingly. If they’re still dodging payments, do not hesitate to escalate the matters to legal and take prompt action in freezing their accounts.
Incentivize early payers
Reward diligent payers with more credits or discounts. This will encourage them to consistently pay in advance which will result in a healthier transaction environment where business-to-business (B2B) relationships thrive.
Shorten invoicing process
Send invoices early to reduce delays in payments. Eliminate redundancies such as inaccuracies in invoice details which can lead to back-and-forth communications. This can also help in reducing DSO (Days Sales Outstanding).
Stay on top of payment terms
Negotiate with your customers from the beginning to decide on a payment term that both parties can mutually agree to. Clear payment terms will make it easier to strategize a customer-focused collection procedure.
Digitize your collections
The time- and labor-intensive nature of collections can be a blocker for businesses in receiving payments in a timely manner. Accounts receivable automation can be the go-to solution to simplify end-to-end invoice-to-payment processes with much less effort and resources.
Streamline Accounts Receivable Collections with Peakflo
Accounts Receivable Turnover Ratio is a critical metric for businesses as it is highly dependable on credit sales, which will give way to positive and stable cash flows.
Reaching a high ratio should be the primary goal for many businesses, so, perfecting the collection strategy will be key.
The reality is, that mapping out a strategic collection procedure is easier said than done for many businesses, especially those who process 100+ invoices monthly.
Manual tasks like constant follow-ups can cause gaps in communications between finance and commercial departments. This could be attributed to the decentralization of the procedure itself, in which the internal teams rely on different touchpoints for communications, tracking, and reporting – only to collect a single invoice.
So, why not consolidate your finance operations in a centralized platform and take more control of your collections? Peakflo can be your source of truth. Our AR automation allows you to:
✅ Set up smart workflows with automated WhatsApp and email payment reminders based on an escalation matrix.
✅ Understand detailed collection efficiency for each month’s invoices.
✅ Access real-time reports to track the deliverability, track the last opened date, and get AI-powered predictions on customers’ payment behavior to further customize your collection strategy.
✅ Keep a tab on customer credit limits via credit control report.
✅ Facilitate a self-serve portal for customers to view and clear invoice payments quicker, or even solve disputes.
✅ Visualize cash flow health and predict future cash inflows.
If you’re looking to improve your accounts receivable process Peakflo’s Accounts Receivable solution can help from invoice delivery to collections worklist. Moreover, gain insights into process health with our AI-powered customizable reports.