A major part of your business is taking in funds. Accounts receivable is an accounting line item that measures how much money clients owe a company.
When your small business renders service or provides customers with products they don’t pay for when they receive them, the money they owe your company becomes part of your accounts receivable.
The accounts receivable turnover ratio measures your small business’s effectiveness at extending credit to its customers and then collecting on those debts.
The Importance of Tracking Accounts Receivable
Tracking your small business’s accounts receivable turnover ratio helps you manage your cash cycle for more efficient use of your assets. By knowing how much money customers owe your company, you can better plan future purchases.
Tracking these numbers and sending notices after a period of time, usually 30 days, helps reduce your risk of customer delinquencies. Also, accounts receivable count as assets on your balance sheet, which can help when your company needs to apply for small business loans.
Calculating Your Accounts Receivable Turnover Ratio
To calculate your business’s accounts receivable turnover ratio, divide your net credit sales by your average accounts receivable. This formula uses the average accounts receivable figure to smooth out the calculation over the time period you analyse. Higher ratios suggest efficient debt collection, while lower numbers point to less efficient debt collection.
Interpreting Your Accounts Receivable Turnover Ratio
The accounts receivable turnover ratio indicates how many times, on average, a business collects on its receivables in one year. A high accounts receivable is more desirable and could imply that:
- Your business collects payments efficiently
- You have quality customers who pay their bills timely
- Your company’s credit policy is restrictive
A low accounts receivable ratio may indicate that:
- Your company employs poor collection processes
- Your customers have trouble meeting payment due dates
- There are issues elsewhere in the business that prevent customers from paying
Average accounts receivable turnover ratios often vary by industry. While retail businesses typically enjoy a higher accounts receivable turnover ratio, companies in the oil and gas extraction industry often see lower ratios, waiting longer to receive payments from their customers.
Examples of Accounts Receivable Turnover Ratio
Imagine your company has $750,000 in net credit sales, $50,000 in accounts receivable at the beginning of the year and $60,000 in accounts receivable at the end of the year. Using the receivable turnover ratio:
$750,000 / (($50,000 + $60,000) / 2) = 13.64
This indicates that the business collects its receivables 13.64 times on average per year. This higher ratio signals an adequate ability to collect on your debts.
As another example, imagine a company has $30,000 in net credit sales, $5,000 in accounts receivable at the beginning of the year and $3,000 in accounts receivable at year end. By applying the account receivable turnover ratio, you find that:
$30,000 / (($5,000 + $3,000) / 2) = 7.5
This signifies that the business collects its receivables only 7.5 times on average per year. This lower ratio indicates the business should probably change its policies and practices to manage cash flow more effectively.
If your small business lets customers set up credit accounts, good tracking habits and accounts receivable management help you keep your accounts receivable turnover ratio high and your cash flow stable.
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