Accounts Receivable Turnover Ratio Definition
Receivables turnover ratio, derived from the balance sheet, measures a company's receivables management efficiency.
ARTR is vital for financial statements because it relies on balance sheet data for average accounts receivable and the income statement for net credit sales.
Receivables refer to the outstanding payments customers owe a company for goods or services provided on net credit sales.
Accounts Receivable Turnover Formula
Accounts Receivable Turnover Ratio = Net Credit Sales / Average Accounts Receivable
Here:
Net Credit Sale (from the income statement) is the total credit sales minus sales returns and sales allowances.
Average Accounts Receivable is the average beginning and ending accounts receivable over a period (a year).
Accounting software, such as accounts receivable automation solutions, helps track ARTR easily.
Accounts Receivable Turnover Ratio Example
Let's walk through an example of calculating the accounts receivable efficiency ratio.
Assume the following information:
- Net Credit Sales for the year: $1,000,000
- Beginning Accounts Receivable: $200,000
- Ending Accounts Receivable: $150,000
Step 1: Calculate Average Accounts Receivable
Average AR = (Beginning Accounts Receivable + Ending Accounts Receivable) / 2
Average Accounts Receivables= ($200,000 + $150,000)/2 = $175,000
Step 2: Apply the receivables turnover ratio formula
Receivable Turnover Ratio Formula = $1,000,000 / $175,000
ARTR ≈ 5.71
Result: The receivable ratio for this company is approximately 5.71.
This means the company collects its receivables about 5.71 times annually on average.
Note: The asset turnover ratio assesses how effectively the company uses its total assets to generate sales.
What is a good accounts receivable turnover ratio?
A higher AR turnover ratio is more favorable and shows that a company collects its receivables quickly.
A lower ratio suggests that the company takes longer to collect customer payments.
A very high turnover ratio shows a stringent policy on the credit memo, affecting sales. It's essential to consider industry norms and business circumstances when analyzing this ratio.
Note: The average collection period calculates the company's days to receive customer payments.
Higher Turnover Ratio vs. Low Accounts Receivable Turnover Ratio
Interpreting a high or low receivable turnover rate provides insights into a company's efficiency in receivables management.
High ARTR
- Efficiency: A high ARTR suggests that a company quickly collects its accounts receivable balance. This is positive and demonstrates efficient credit and collection management.
- Cash Flow: A high turnover ratio means the company rapidly converts net sales to cash and improves cash flow.
- Risk: While a high ARTR is good, high values affect sales. It's vital to balance quick collections with sales growth.
Low ARTR
- Inefficiency: A low ARTR indicates that a company takes longer to collect payments, which shows credit and collection process inefficiencies.
- Cash Flow Concerns: A lower turnover ratio leads to lower cash inflows and affects the company's liquidity and short-term obligations.
- Credit Policy Considerations: Some industries naturally have longer credit cycles.
Receivables Turnover Ratio vs. Days Sales Outstanding
Days sales outstanding (DSO) shows the average days a company takes to collect payments after sale.
Calculate DSO by dividing the total accounts receivable during a specific period by the total net credit sales and multiply the result by the days.
DSO is a direct measure of the collection process time. A lower DSO means the company collects quickly.
The accounts receivable turnover ratio reveals collections frequency and the latter provides customer debt collection duration.
Understanding these metrics' nuances allows companies to manage credit policies and cash flow better.
Accounts Receivable Turnover Ratio Importance
Efficiency Measurement
ARTR measures how efficiently a company can collect payments from its customers. A higher ratio indicates that the company is managing its receivables more effectively.
Cash Flow Management
A high ARTR indicates that the company quickly converts total credit sales into cash sales and this improves its cash flow position.
Working Capital Management
ARTR is tied to working capital and provides insights into short-term assets and liabilities management.
Credit Policy Evaluation
ARTR evaluates credit policy effectiveness. A high value shows a well-structured payment term and customers' payment quickness. A low value suggests lenient credit policies or collection difficulties.
Liquidity Assessment
Quick and efficient collection strategies indicate how well a company meets its short-term obligations.
Financial Modeling
Through financial modeling, ARTR is benchmarked against industry averages and competitors. Comparing ARTR to industry norms helps identify strengths or improvement areas.
Financial Health Indicator
A consistent and healthy ARTR indicates positive financial health. It signals effective working capital management and healthy sales and cash collections.
Investor and Creditor Confidence
Investors and creditors use this metric to determine a company's financial stability. A strong ARTR improves stakeholders' confidence in cash generation.
Early Warning System
A significant ARTR change is an early warning signal. A sudden decrease shows credit quality issues, customer payment changes, or liquidity problems.
Limitations of Accounts Receivable Turnover Ratio
Despite ARTR's usefulness, it has several limitations:
- Receivables Quality: It treats all receivables equally. Some receivables are at high default risk but don't differentiate and present an optimistic collections view.
- Payment Patterns: It averages receivables, masking issues like seasonal fluctuations or large accounts.
- Credit Policy: Credit policy changes inflate the ratio without improving efficiency. Therefore, it's essential to consider policy changes.
- Manipulation: Companies can manage receivables timing around the reporting period to temporarily improve the ratio. This makes the company's financial performance appear better than it is and misleads stakeholders.
- Historical: ARTR is based on past transactions and cannot accurately predict future performance, especially in high-growth industries. It's a retrospective measure and doesn't account for upcoming challenges or opportunities.
- Industry: Comparing the accounts receivable turnover ratio across different industries or different sizes is misleading due to business model differences, customer bases, and credit practices.
Improving Accounts Receivable Turnover Ratio
Improving ARTR enhances receivable management efficiency and speeds up the outstanding payment collection.
Streamline Credit Policies
Review and refine credit policies to balance customer attraction and credit risk mitigation. Clear and well-communicated net terms encourage prompt payment.
Credit Screening
Implement screening processes to evaluate customers' creditworthiness. This helps reduce late payment and default risk.
Invoice Clarity and Timeliness
Ensure the invoices are accurate, easy to understand, and promptly sent. Clear and quick invoices lead to faster customer payments.
Offer Discounts for Early Payment
Consider offering early payment discounts to customers who pay on time. This encourages quick payments and improve cash flow.
Implement Late Payment Penalties
Include late payment penalties in credit terms. This motivates customers to adhere to payment deadlines and discourages late payments.
Monitor and Analyze ARTR
Monitor ARTR and analyze trends. Identifying changes helps quickly tackle issues and capitalize on strategies.
Effective Communication
Maintain communication regarding payment expectations. Address any issues or concerns to prevent payment delays.
Automate Invoicing and Collections
Implement automation tools for invoicing and collections to streamline processes and reduce error likelihood.
Educate Sales Teams
Ensure your sales team understands how important invoicing is and how it positively influences receivables collection. Match sales incentives with healthy ARTR maintenance.
Customer Segmentation
Segment customers based on payment behavior and create targeted strategies for different groups. This is more effective to manage diverse customers.
FAQs
1) What is a good accounts receivable turnover ratio?
A good accounts receivable turnover ratio exceeds 10. This indicates that a company collects its receivables more than ten times yearly or approximately every 36 days.
2) How do you calculate receivable turnover?
To calculate the receivable turnover ratio, divide the total net credit sales by the average accounts receivable during the period.
3) What does a higher or lower receivable turnover ratio mean?
A higher receivable turnover ratio means a company collects its debts quickly, indicating efficient credit and collections management, while a lower ratio suggests slower collections and potential cash flow issues.
4) How do you calculate creditors turnover ratio?
To calculate the creditor's turnover ratio, divide the total net credit purchases by the average accounts payable during the period.
