Collecting cash is a critical part of your company's AR cycle. Efficient collections smooth cash flow and working capital projections, helping you chart your business' course. The Accounts Receivable Turnover ratio (AR Turnover ratio) measures collection efficiency and offers several benefits.
In this guide, you will learn what the AR turnover ratio is, along with the following:
What is the accounts receivable turnover ratio?
The accounts receivable turnover ratio measures how quickly your customers pay their invoices. This metric is also called the debtor’s turnover ratio or receivables turnover. Its primary purpose is to measure how efficiently your company collects cash. You can calculate this ratio using data from your financial statements.
In accounting terms, the AR turnover ratio measures how quickly a company turns its receivables into cash. For example, company A offers all its customers Net 30 payment terms. While most of its customers pay within this period, some pay after 45 days.
Company A will therefore collect cash on its invoices a little over 30 days after issual. A's AR turnover ratio will be low as a result. You will learn how to calculate the AR turnover rate with a formula later in this article.
How the AR turnover ratio works
The receivables turnover ratio is a part of a company's financial planning and analysis process. It gives CFOs a quick picture of how soon the company can expect cash to enter its bank accounts. A low value means cash takes a while to reach your bank account, and a high turnover ratio indicates quick cash collection or a conservative credit policy.
You will learn why a low ratio indicates long collection times in a later section where we explain the AR turnover ratio formula, along with an example. For now, let us review how financial teams rely on the ratio.
The AR turnover helps companies using accrual accounting connect the dots between cash and revenue. In accrual accounting, a company often recognizes revenue before cash enters its bank account.
The AR turnover ratio gives your financial department a measure of the gap between revenue recognition and cash collection, factors that impact your income statement. A low AR turnover value indicates a gap that could jeopardize your financial stability.
A low AR turnover does not indicate poor collection practices by itself. CFOs and accountants view the AR turnover with other financial metrics such as AR aging, bad debt, and collection probabilities to determine cash flow health. In some industries, credit cycles of 60 days are common, decreasing AR turnover ratios.
In contrast, industries such as retail have high AR turnover ratios because they collect cash immediately from customers. However, this high number does not mean retail is a better business sector than others with lower AR turnover values.
Why is the accounts receivable turnover ratio important?
The AR turnover ratio offers financial departments the following insights:
- Gives you a snapshot of invoice collection efficiency
- Offers a starting point for root cause analysis of non-payment and customer disputes
- Highlights impending problems with your cash flow
- Reveals AR department efficiency
- Offers insight into credit term suitability
- Helps CFOs measure financial performance
How to calculate accounts receivable turnover
Here is the accounts receivable turnover ratio formula:
AR turnover ratio = Net credit sales / Average accounts receivable balance
As you can see, you must calculate the accounts receivable turnover formula's inputs first. Here's how you can do this step by step.
Step #1: Calculate net credit sales
The accounts receivable turnover formula considers just credit sales since cash sales do not create receivables. You receive cash immediately, bypassing the need to record receivables.
You can calculate your net credit sales via the formula below:
Net credit sales = Total credit sales - Sales returns and refunds - Sales allowances
Sales returns refer to any refunds you issued to your customers. Sales allowances include credit notes or any other allowance you offer your customers.
Let's assume our company, Acme Inc, recorded the following numbers last accounting period. Here's what its net sales will look like:
- Total credit sales = $3,000,000
- Returns = $100,000
- Allowances = $20,000
- Net credit sales = 3,000,000 - 100,000 - 20,000 = $2,880,000
Step #2: Calculate the average accounts receivable
Average AR is the second input in the receivables turnover formula. As the name suggests, this number is the average receivables amount your company has recorded over a certain period.
The formula for average AR is:
Average accounts receivable = (Receivables at the start of the period + Receivables at the end of the period) / 2
Let's assume Acme had the following numbers. Its average AR is:
- Receivables at the start of the period = $500,000
- Receivables at the end of the period = $ 475,000
- Average AR = (5,000,000 + 4,750,000) / 2 = $487,500
Step #3: Apply the accounts receivable turnover formula
As a reminder, the accounts receivable turnover formula is:
AR turnover ratio = Net credit sales / Average accounts receivable balance
Here are the values for our example company, Acme Inc:
- Net credit sales = $2,880,000
- Average AR = $487,500
- AR turnover ratio = 2,880,000 / 487,500 = 5.9
This number doesn't make much sense from a business standpoint. Therefore, we convert it to days using the formula below:
AR turnover in days = 365 / AR turnover ratio
In Acme's case, this is:
AR turnover in days (average number of days to collect) = 365 / 5.9 = 61.89 = ~62 days
This means Acme has an average collection period of 62 days on its credit sales. The question now is: Is Acme's AR turnover good or bad?
What is a good receivables turnover ratio?
You must account for business context when analyzing an AR turnover value. Here's how you can do this.
AR turnover ratio benchmarks
One of the easiest ways to bring context to your data is to examine your results against benchmarks. In AR turnover's case, there are very few definitive benchmarks publicly available.
Stock research firm CSI Markets published data across several industries in 2022. However, the firm has not disclosed its sampling methods or collection practices. However, its data does adhere to what one would expect.
CSI's study lists the retail, consumer non-cyclical, and transportation sectors as the best performers. The financial sector ranks worst, with a turnover ratio of 0.22. However, this number highlights the problem with CSI's study.
The financial sector is very diverse. CSI is grouping investment banks with merchant cash advance companies, businesses with wildly different customers and collection practices. Therefore, consider these data with a pinch of salt.
How to interpret your AR turnover ratio
Since AR turnover benchmarks do not offer the best data, how can you analyze your metrics? The first step is to bring context to your turnover value. You can begin by defining your sector as tightly as possible. For instance, we can define Acme's business sector as "wholesale food supply" instead of "consumer non-cyclical."
Next, take a look at your working capital structure. Are credit sales a major portion of your total sales? Or do you primarily collect cash when selling? The ratio of cash to credit sales will help you determine whether your AR turnover ratio is important or not. Remember, AR turnover only considers net credit sales.
For instance, if Acme's sales are 90% cash, a low AR turnover ratio will probably not mortally affect its business. Acme can continue to collect cash while offering generous credit terms to selected customers.
However, if credit accounts for 90% of sales, a low accounts receivable turnover ratio spells potential danger. A low number does not reveal much.
We must take our analysis a step further by examining Acme's competitors' credit policies and payment plans. Examining their pricing structures is also instructive since we want to compare apples to apples. For example, if a competitor sells only confectionery while Acme offers a wide range of food, comparing the two does not make sense.
Pick a competitor similar to you and examine their pricing and payment terms. You can reasonably estimate their AR turnover ratio and compare it to yours.
Finally, remember that comparisons only go so far. You might be collecting cash per the industry average, but your working capital position might be less-than-desirable. Always strive to improve your financial position and increase your AR turnover ratio.
You'll learn how to achieve these goals in a later section. For now, here's a summary of how you can analyze your AR turnover ratio:
- Look at industry benchmark data to see where you stand.
- Bring more context by tightly defining your business sector and activity.
- Examine your working capital and payment acceptance modes - If credit sales are a small portion of revenues, AR turnover values might be insignificant.
- Examine your closest competitors' revenues, payment terms, business structure, and pricing. Compare apples to apples.
- Examine your working capital and cash collection efficiency to categorize your AR turnover ratio. Always strive to improve this metric.
Limitations of the AR turnover ratio
Some financial teams get lost in measuring their AR turnover ratios and forget that this is just one metric amongst many. While the receivable turnover ratio is great, it has a few limitations you must consider.
Represents an average
The accounts receivables turnover ratio captures your average customers' payment behavior. If all of your customers behave similarly, the ratio will work well for you. However, the number doesn't represent much if you have widely divergent customers.
Let's assume Acme has two customers, A and B. A accounts for 60% of Acme's sales and B the rest. Let's also assume both customers pay exclusively on credit for simplicity's sake. If A regularly pays within one day of receiving an invoice while B pays on a Net 90 basis, the AR turnover in days will lie somewhere around the 40-day mark.
40 days is an unrealistic representation of how Acme collects cash. Calculating A's and B's individual AR turnovers makes more sense in this case. However, these calculations are tedious if you have a large customer base .
Calculating individual customers' Day Sales Outstanding (DSO) is easier and offers context faster than the receivables turnover here.
Does not zero in on default risk
Receivables turnover offers you a look at how quickly you are converting invoices to cash. It does not warn you of non-payment trends per customer or their risk of defaulting on invoices. Thus, concentrating solely on AR turnover is inadvisable when viewing your AR efficiency metrics.
For example, if a customer's payment period has been steadily increasing over time, the AR turnover ratio will not reveal the problem. You will notice changes in the metric. However, the turnover is an average. It smoothes any adverse circumstances in individual customers and you cannot measure their creditworthiness.
Focus on customer-level metrics and check your AR aging tables to pinpoint issues with delayed payments.
Cannot account for seasonality
A common problem with the accounts receivable turnover ratio is the lack of context it offers. For example, let us assume Acme Inc experiences a lull in cash flow during the summer and an influx in winter. Acme's customers will also likely experience the same issue, leading to longer repayment times during summer.
Thus, Acme's AR turnover ratio will decrease in summer and rise in winter. Does this mean Acme's business and customer quality have dramatically changed? Not quite.
You cannot make blanket assumptions if your company’s accounts receivable ratio is high or low. You must view data in context at all times.
Needs additional context
As previously mentioned, the AR turnover ratio does not reveal much without context. It gives you a snapshot of collection efficiency but is merely a starting point for further analysis. Always view it with other AR metrics such as DSO, AR aging tables, and collection probability percentages.
5 tips to improve your AR turnover ratio
Here are some of the best ways to improve your receivables turnover ratio.
Align credit policies with AR data
The faster you collect on invoices, the better your AR turnover ratio is. Customer disputes caused by invoice errors like incorrect payment terms and prices delay collections. One of the reasons for these errors is AR teams being out of sync with the terms customers receive from sales.
For instance, sales might promise customers a Net 45 payment period instead of the usual Net 30. AR will thus begin following up on payment after 30 days, leading to a poor experience for the customer.
Aligning AR and sales using cash flow data will align both teams and deliver great customer experiences. As a result, your AR team will make fewer errors, have lesser manual follow-ups to execute, and collect on invoices faster.
Incentivize early payments
One of the best ways to get customers to pay you faster is to help them save money. Offering early payment discounts will reduce your collection times without significantly lowering your margins. Best of all, you'll align yourself with your customers' accounts payable (AP) priorities.
Deloitte highlights capturing early payment discounts as one of the best ways to improve AP processes. Offering an early invoice payment discount demonstrates your understanding of customer priorities, something that will speed up collections and build better customer relationships.
Use electronic and automated solutions
Manual processes slow collection times, increase invoicing errors, and hamper speedy dispute resolution. Financial management software automates many manual tasks and offers several benefits. Here are some of them:
- Increases workforce ROI: Automation gives employees time to conduct root-cause analysis and uncover holes in your AR processes.
- Decreases collection times: Reduced errors and more organizational alignment ensure fewer disputes. The result is quick collections.
- Better visibility: Electronic software offers you deep cashflow insights. You can spot upcoming cash flow problems quickly and move to mitigate them. The result is better cash collection.
- Better communication and collaboration: Software centralizes all AR data and simplifies collaboration. Finance teams can work together to increase efficiency. The result is more organizational alignment, better customer communication, and faster collections due to strong customer relationships.
- Drill down into issues: Electronic platforms help you isolate root causes and dig deeper into issues. For instance, you can seamlessly switch between an organization-wide AR turnover view to a customer-centric view and analyze trends.
Make it easy to pay
Offer a diverse range of payment channels to your clients. Every customer has different AP processes that call for varied payment channels. Some prefer ACH transfers, while others prefer virtual corporate credit card payments.
Give your customers ample payment choices, and you will collect cash quickly.
The accounts receivable turnover ratio measures how efficient your AR processes are. While a useful financial ratio, resist relying on it solely since it has a few limitations. Bring more context when analyzing your AR turnover ratio, and you will decrease collection times and boost profitability.