Accounts receivable turnover ratio explained

Businesses often allow customers a period of credit on a purchase, especially for bulk payments. However, the time taken to recover the outstanding payments from each debtor also plays a big part in the business’s overall performance. And that is exactly what the accounts receivable turnover ratio tells us.

Accounts receivable meaning and relevance

Accounts receivables refer to all the customers that owe the business money for goods or services provided by the business. Businesses often offer a credit period to their customers to fulfil the payments conveniently, especially for bulk orders. Since accounts receivables constitute money that is yet to be received (cash inflow), they are shown as assets in the business’s balance sheet.

There is also an element of risk that cannot be ignored when it comes to accounts receivables. More often than not, a few of those receivables turn to doubtful debts and, eventually, bad debts, given the risk of non-payment. Because of this, businesses sell goods on credit to regular and reliable customers only to reduce the default risk.

For the purpose of calculation of the Accounts Receivable Turnover Ratio, Average Accounts Receivables will be-

(Accounts Receivables at the beginning of the year + Accounts Receivables at the end of the year) / 2

Turnover definition for businesses

Specific to the account receivables turnover ratio, the definition of turnover focuses mainly on credit sales. The focus is only on credit sales here because cash sales do not create accounts receivables. Therefore, for the purpose of calculation of the Accounts Receivable Turnover Ratio, turnover will comprise of-

Net credit sales = Credit Sales – Sales Returns – Sales Allowances (Discounts) 

How to interpret the accounts receivable turnover ratio

A business’s accounts receivable turnover ratio measures how well it can convert credit transactions into cash. It depicts the number of times a business can collect its account receivables in a given year. The collection period often differs from business to business.

Some businesses are able to collect their accounts receivables within 90 days, some take two months, some others take up to six months as well. It is a business’ loss to wait longer to collect on its credit. This is because the credit period given by the businesses to the customers to make the payment does not involve any interest charges.

The formula for Accounts Receivable Turnover Ratio is as follows-

Annual Net Credit Sales  / Average Annual Accounts Receivables

Accounts Receivable Turnover depicted in days will be-

365 / Accounts Receivables Turnover Ratio

Example: Raj’s Flower Shop caters to corporate events by providing them with floral arrangements. The sales are usually on a credit basis. The shop has amassed Rs.10 lakh in credit sales. The accounts receivables at the beginning of the year were Rs.2.5 lakh. At the end of the year, it was Rs.3.2 lakh.

The accounts receivable turnover ratio is calculated as follows-

Average accounts receivable = (2,50,000 + 3,20,000) / 2 = Rs. 2,85,000

Accounts receivable turnover ratio = Net Credit Sales / Average Annual Accounts Receivables = 10,00,000 /  2,85,000 = 3.51

Therefore, the company’s accounts receivable turned over 3.51 times, which means that the average accounts receivables were collected in 103.9 days (365 days ÷ 3.51 times).

Benefits of knowing this ratio and applications

• Leads to enhanced cash inflows

The ratio depicts the time taken by the business to convert its credit transactions to cash. This helps the business plan accordingly to ensure timely a quick turnaround of credit transactions to cash.

• Reduced bad debts and write-offs

Often, businesses would suffer huge losses on non-payment of dues by the customers. With the help of this ratio, the business can better manage the volume of credit sales and offer the option of credit sales to its most reliable and regular customers, thus ensuring a reduction in write-offs and bad debts.

• Stronger credit policies

Based on the ratio revealed, the business may choose to tighten up its existing credit policies to avoid problems such as being cash-strapped or customers defaulting on payments. 

• Reduced time for debt collection

As a result of the enhanced credit policies, the time to recover the outstanding debt will decrease accordingly. This, in turn, will enhance cash inflows as well.

Tips to improve the accounts receivable turnover ratio for business

• Timely and accurate invoicing

Sending your clients/customers professional invoices with accurate details is essential to receive the payments on time. Another practice that can help with quicker receipt of dues is to invoice the clients on time.

• Build and maintain strong customer relationships

Customer satisfaction is an essential part of the business. Building meaningful and long-standing relationships with customers can go a long way towards ensuring timely payments are made by them. Happy and satisfied customers are always inclined to pay when requested.

• Make a payment of invoices convenient

Offering customers convenience about the method of payment often leads to a win-win situation. The customer has the freedom to select the most convenient method, and the business can collect the debts quicker.

• Use cloud-based software

The billing process and receivables tracking become a whole lot easier when could-based software is used. Moreover, accessing and updating the data can be done on the go, thus facilitating convenience.

• Regular follow-ups

Sending across a gentle reminder for dues through an email, call or text makes a world of difference to the customers. It helps build customer relationships and also ensures payments are made promptly.