What Is Accounts Receivable (AR) Turnover Ratio?
The number of times a company is able to collect its average receivables in a period is measured using the accounts receivable turnover ratio. It determines the effectiveness of a company to collect its outstanding receivables from its customers. This ratio quantifies the company’s efforts so they are able to identify areas for better improvement.
A higher ART ratio shows that a company is doing well in terms of collecting its payments. On the other hand, a lower accounts receivable turnover ratio shows the inefficiency of the company in promptly collecting receivables. Companies use this ratio to compare their performance with that of other companies in the same industry.
- ART ratio calculates the number of times a company is able to collect its outstanding receivables from its debtors.
- A higher ratio indicates an efficient collection process and that the company is able to collect its debts quickly. This also means that the company has a stringent collection process.
- A low ART ratio indicates inefficiencies in the collections process or lenient credit policies. If not altered, over a period of time the company can end up accumulating higher amounts of bad debts.
- ART ratio also tells you how your company is performing when compared to other companies in the industry and shows how the performance is over time.
- The accounts receivable turnover ratio helps in cash flow analysis, identifies ineffective billing practices, and assesses your current credit policy.
Accounts receivable turnover ratio explained
Accounts receivables are short-term interest-free credit offered by a company to its customers in the form of goods or services purchased. Companies allow a certain amount of time for the customers to repay in terms of cash for the product or service purchased.
For instance, if a company sells its products on credit for a customer, they usually draft a 30-60 days TAT for the payment. The accounts receivable turnover ratio will tell the number of times the company was able to convert its receivables into cash during a certain period. This is calculated annually, monthly, or quarterly.
How to Calculate Accounts Receivable (AR) Turnover Ratio
The accounts receivable turnover ratio is calculated using net credit sales and average accounts receivable.
Accounts receivable turnover ratio = Net credit sales / Average accounts receivable
- Net Credit Sales - Net credit sales are the total amount of sales the company has done on credit to its customers. Net credit sales are calculated by taking into account total credit sales in a period minus the returns and allowances if any. Cash sales are not considered in this. Net credit sales should always be calculated based on a particular time period and any future possible returns in that period should also be considered while calculating.
- Average Accounts receivable - Average accounts receivable is calculated by taking into account the receivables balance at the beginning and the end of a time period.
Importance of Accounts Receivable Turnover Ratio
- Gauge the company’s collections process - Calculating the accounts receivable turnover ratio will assist a company in comparing the efficiency of its collections process to that of other companies in the industry. This helps them understand how quickly they can collect debts in comparison to other companies and plan & manage their cash flows.
- Assess credit policies - One primary reason why it gets difficult for companies to collect debts is that they don’t have strict credit policies. Customers often use this as a loophole to delay payments.
- Better financial planning - Accounts receivable funds can be converted to cash within one year, making them a current asset. Companies can effectively use cash from accounts receivable to meet their working capital requirements. The accounts receivable turnover ratio will aid in effective cash management through forecasting
High AR turnover ratio vs Low AR turnover ratio
A high AR turnover ratio suggests that the company has a very practical solution for dealing with customer debts. The company has stricter credit policies and is more conservative in granting credit to those who may not have a good repayment reputation. However, businesses must strike a balance between drafting strict credit policies with proper background checks and being approachable for credit purchases. Customers may find it difficult to obtain credit due to strict policies, and they may turn to competitors who offer credit. This can lead to customer loss and/or slowed business growth.
A low accounts receivable turnover ratio is a bad sign for a business. This demonstrates that they lack a proper debt collection strategy, which results in accumulated debt. Bad credit policies, an inefficient collections team, or manually collecting debts can all be reasons for a low AR turnover ratio. A lower ratio indicates that there is more money with debtors, which may be unrecoverable. When it comes to slower collections, the quality of the product or service offered is also important. Customers may be unwilling to pay if they are dissatisfied with the product's quality.
Tips to Improve Your Accounts Receivable (AR) Turnover Ratio
1. Invoice regularly and accurately
Sending invoices on time and with less or no errors can help improve the ART ratio. Businesses should also proactively aim to start sending reminders at an earlier date than the due date to ensure they are properly following up with customers for the payment. Invoices should be free of ambiguity and errors for faster processing. An automated billing and invoicing system is a great way to ensure quality and streamline invoice generation processes.
2. Always state payment terms
Clear payment terms can help define the efficiency of your collections process. Customers frequently feel at ease when they think the credit policy is not stringent enough to bind them into a contract. Drafting accurate and rigid credit policies and conducting a thorough background check before extending credit to a customer is one way to ensure that no loopholes exist in this process. When dealing with customers who buy on credit, stating the consequences of non-payment of invoice amounts can add weightage.
3. Offer multiple ways to pay
Another reason why customers might find it difficult to repay is due to restricted payment options. While some businesses are able to pay in cash, others might prefer bank transfers or pay through cards and other digital transactions. Also offering discounts on early payment is another way of encouraging customers to make payments promptly.
4. Get the advantage of automated tools
Quicker payments need faster processing. The manual collections process puts a stopper to an efficient collections strategy. This can affect your company’s AR turnover ratio heavily. Using automated tools for billing, invoice generation, and collections process can improve and expedite the way you collect payments.
Improve Accounts Receivable Ratio with Growfin
Accounts receivable turnover ratio can help understand how quickly you are able to collect your outstanding payments from your debtors. Customers can often delay paying you for their credit purchases. But it is always wise to take proactive measures to expedite the collections process so you have a stable cash flow. Collections delays can end up in increased bad debts and eventually financial doom for the company.
Growfin can help you improve your accounts receivable turnover ratio through its easy-to-use and efficient collections automation tool. Spend less time on collections and say goodbye to manually collecting invoices. Instead, spend more time creating effective collection strategies. Growfin can help improve your team productivity by 50% and improve your DSO to a great extent.