80% of small business owners feel stressed about cash flow, according to the 2019 QuickBooks Cash Flow Survey. And more than half of them cite outstanding receivable balances as their biggest cash flow pain point. But nearly half of them claim those cash flow challenges came as a surprise.
Knowing how to calculate the accounts receivable turnover ratio formula can help you avoid negative cash flow surprises. Knowing where your business falls on this financial ratio allows you to spot and predict cash flow trends before it’s too late. Tracking this ratio is a bookkeeping staple.
What is the accounts receivable turnover ratio?
The accounts receivable turnover ratio, or debtor’s turnover ratio, measures how efficiently a company collects revenue. Your efficiency ratio is the average number of times that your company collects accounts receivable throughout the year. An average accounts receivable turnover ratio of 12 means that your company collects its receivables 12 times per year or every 30 days.
A higher accounts receivable turnover ratio indicates that your company collects funds from customers more often throughout the year. On the flip side, a lower turnover ratio may indicate an opportunity to collect outstanding receivables to improve your cash flow.
The accounts receivable turnover ratio is a type of efficiency ratio. Efficiency ratios measure a business’s ability to manage assets and liabilities in the short term. Other examples of efficiency ratios include the stock turnover ratio and asset turnover ratio. Efficiency ratios can help business owners reduce the amount of time it takes their business to generate revenue.
Why is it important to track accounts receivable turnover?
Your accounts receivable turnover ratio measures your company’s ability to issue a credit to customers and collect funds on time. Tracking this ratio can help you determine if you need to improve your credit policies or collection processes. Additionally, when you know how quickly, on average, customers are paying their debts, you can more accurately predict cash flow trends. And if you apply for a small business loan, your lender may ask to see your accounts receivable turnover ratio to determine if you qualify.
It’s important to track your accounts receivable turnover ratio on a trend line to understand how your ratio changes over time.
A higher ratio can mean a few things:
- You have a conservative credit policy: A too-high ratio can indicate that your credit policy is too aggressive. Your credit policy may be dissuading some customers from making a purchase. If your ratio is consistently very high, you may want to consider loosening your credit policy to make way for new customers.
- You have an efficient collections department: And you have high-quality customers. A high ratio indicates that your customers pay their debts on time. This means your collection methods are working, and you’re extending credit to the right customers.
- You operate mostly on a cash basis: Your accounts receivable turnover ratio will likely be higher if you make cash sales primarily.
A lower ratio can indicate a few things:
- Your collections policies aren’t working. A low ratio, or a declining ratio, can indicate a large number of outstanding receivables. If that’s the case, this is a good opportunity to revisit your collection policies and collect invoices past due or late payments.
- Your credit policies are too loose: If your ratio is too low, it may indicate that your credit policy is too lenient, the result of this is bad debt. Bad or uncollectible debt occurs when customers can’t pay. Consider revamping your credit policy to ensure you’re only extending credit to the right customers.
- Your customers are struggling to meet your payment terms: If your payment terms are too stringent, customers may struggle to meet them. And they might avoid making future purchases from your business because of it. If your ratio is low, take a look at your payment terms. Consider offering more payment methods or payment plans for customers struggling to pay.
How to calculate your accounts receivable turnover ratio
Calculating the accounts receivable turnover ratio is simple. You can find all the information you need on your financial statements, including your income statement or balance sheet.
First, you’ll need to find your net credit sales for the year or all the sales customers made on credit. Invoices indicate a credit sale to a customer. You collect the money from credit sales at a later date.
To calculate net credit sales, subtract sales returns and sales allowances from all sales on credit. Find these numbers on your income statement or balance sheet.
The formula for net credit sales follows:
Sales on credit – sales returns – sales allowances = net credit sales
Next, you need to calculate your average accounts receivable. Average accounts receivable is the sum of starting and ending accounts receivable over an accounting period, divided by two. You can find the total accounts receivable on your balance sheet.
The formula for average accounts receivable follows:
(Starting accounts receivable + ending accounts receivable) ÷ 2 = average accounts receivable
Then divide your net credit sales by your average accounts receivable to find your accounts receivable turnover ratio.
The accounts receivable turnover formula follows:
Net credit sales ÷ average accounts receivable = accounts receivable turnover ratio
A turnover ratio of 4 indicates that your business collects average receivables four times per year or once per quarter. If your credit policy requires payment within 30 days, you might want your ratio to be closer to 12.
Determining whether your ratio is high or low depends on your business. If you choose to compare your accounts receivable turnover ratio to other companies, look for companies in your industry with similar business models.
Accounts receivable turnover ratio example
Centerfield Sporting Goods had R250,000 in net credit sales in 2019. They found this number using their annual income statement.
The company’s average accounts receivable for 2019 was R50,000. They found this number using their January 2019 and December 2019 balance sheets. At the beginning of the year, in January 2019, their accounts receivable totalled R40,000. In December 2019, their accounts receivable totalled R60,000. They used the average accounts receivable formula to find their average accounts receivable.
(R40,000 + R60,000) ÷ 2 = R50,000
To find their accounts receivable turnover ratio, Centerfield divided its net credit sales (R250,000) by its average accounts receivable (R50,000).
R250,000 ÷ R50,000 = 5
Their accounts receivable turnover ratio is 5. They collect average receivables five times per year or every 73 days.
Centerfield Sporting Goods specifies in their payment terms that customers must pay within 30 days of a sale. Their lower accounts receivable turnover ratio indicates it may be time to work on their collections procedures. In doing so, they can reduce the number of days it takes to collect payments and encourage more customers to pay on time.
Making decisions based on your accounts receivable turnover ratio
In general, a higher turnover ratio is better for your business. A higher turnover ratio means you don’t have outstanding receivables for long. Your customers pay quickly or on time, and outstanding invoices aren’t hurting your cash flow.
However, a turnover ratio that’s too high can mean your credit policies are too strict. You may be alienating potential customers. Use your turnover ratio to determine if there’s room to loosen your policies and make way for more sales.
A lower ratio means you have lots of working capital tied up in outstanding receivables. You may have an inefficient collections process, or your customers may be struggling to pay. Use your ratio to determine when it’s time to tighten up your credit policies. You can use it to enforce collections practices or change how you require customers to pay their debts. Customers struggling to pay may need a gentle nudge, a payment plan, or more payment options.
How to improve your receivables turnover ratio
If your accounts receivable turnover ratio is lower than you’d like, there are a few steps you can take to raise the score right away.
- Improve your collection process: Your collection process determines how you collect funds from customers. If you’re struggling to get paid on time, consider sending payment reminders even before payment is due. Implement late fees or early payment discounts to encourage more customers to pay on time. If you can, collect payment information upfront to automatically collect when payment is due.
- Include clear payment terms: Your customers might not realise their payments are past due. Encourage more customers to pay on time by setting a clear payment due date, sending detailed invoices, and offering additional payment options.
- Make payments easy: If you only accept one payment option, you may be creating a roadblock to getting paid. Accepting a variety of payment options like credit cards or digital payments removes any unnecessary barriers.
- Build strong relationships: Happy customers who feel invested in you and your business are more likely to pay up on time—and come back for more. Focus on building strong personal relationships with your customers to keep the cash flow coming in.
- Use cloud software: Cloud-based accounting software, like QuickBooks Online, makes the process of billing and collecting payments easy. Automate your collections process, track receivables, and monitor cash flow in one place.
