Accounts Receivable Turnover Ratio: Definition and Formula

The Accounts Receivable (AR) 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, Peakflo 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 (AR) Turnover Ratio?

The accounts Receivable (AR) Turnover 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 (AR) 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.

To determine the Average Accounts Receivable 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 dividing by the number of months in the allocated period.

For example, if a company had $500,000 in net credit sales during a year and an average accounts receivable balance of $50,000 during that same year, its Accounts Receivable Turnover Ratio would be 10 ($500,000 / $50,000).

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).

The Example of Accounts Receivable (AR) Turnover Ratio

Let’s see take a practical example to better understand the concept of Accounts Receivable Turnover Ratio.

Suppose a company, ABC Ltd., had Net Credit Sales of $1,000,000 last year and its average Accounts Receivable Balance was $100,000. The company’s Accounts Receivable Turnover Ratio should be as follows:

Accounts Receivable Turnover Ratio = Net Credit Sales / Average Accounts Receivable = $1,000,000 / $100,000 = 10

In other words, that ABC Ltd. collects its accounts receivable balance around ten times on average during the year.

Alternatively, we can calculate the Accounts Receivable Turnover Ratio in Days as such:

Accounts Receivable Turnover Ratio in Days = 365 / Accounts Receivable Turnover Ratio = 365 / 10 = 36.5 days

This means on average, ABC Ltd. takes 36.5 days to collect payments from its customers.

What Is a Good Accounts Receivable Turnover Ratio?

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 expeditious payment collection 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 is too aggressive in implementing collection strategies 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.

In the short and continuous term, having a high AR Turnover 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.

So… Is the Accounts Receivable Turnover Ratio Important?

Yes, it is highly important for businesses of any size.

Here are the key reasons why Accounts Receivable Turnover Rate is important:

1. Cash Flow Management. The Accounts Receivable Turnover Rate gives transparency into how quickly and effectively the collection strategy of a company is. For any business, cash is king, and a good collection flow will benefit the overall cash flow of the company.
2. Credit Management. 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 AR Turnover Rate, it means that they are successful in streamlining credit and AR management, therefore bringing more profit to the company.
3. Performance Evaluation: Internally, the Accounts Receivable Turnover Rate can be an assessment to improve the practical methods of collecting customer payments. Externally, it is concrete proof that can persuade investors and creditors into providing access to wider monetization channels and lowering borrowing costs.
4. Strategic Decision Making: The Accounts Receivable Turnover Rate 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:

1. Tighten credit policies: Your business should be stricter and tighter in establishing credit regulations, especially for late payers, such as by personalizing the payment reminder messages. If they’re still dodging payments, do not hesitate to escalate the matters to legal and take prompt action in freezing their accounts.
2. 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.
3. Shorten invoicing process: Send invoices early to reduce delays in payments. Eliminate any 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).
4. 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.
5. 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

In conclusion, 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, and so, perfecting the collection strategy will be key.

The reality is, mapping out a strategic collection procedure is easier said than done for a lot of 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.

Peakflo has helped 300+ teams across APAC in reducing the collection cycle to 15-20 days, and you can be the next one. Book a call with our expert for free, or see how much you can save with us with the ROI calculator.