Accounts Receivable Turnover Ratio

What is the Accounts Receivable Turnover Ratio?

The Accounts Receivable Turnover Ratio measures how often a company collects its average account balance for the period being measured.

It’s used to calculate how often a company gets money in its hands compared to the amount of credit sales it makes.

Most companies want to have higher ratios because it proves that a company is effective in collecting credit. The risk of having a ratio too high is that there may be good customers who don’t have access to credit, and the company is too conservative.

The ratio can be affected by many factors, including:

• The industry of the company
• Creditworthiness of the customers
• The size of the company. 

…and more defined near the end of this article.

There is not a ratio that a company targets specifically, but most companies want to have a ratio greater than 1.

The ratio can be used to influence the strategy decisions of the company. Some companies may feel like their customers do not pay their money on time, so they may have tighter conditions to qualify for credit sales, or some may want to loosen them to bring in more customers. 

What are Accounts Receivable?

It’s money owed to a company by its customers on certain terms. On average, the customer has about 30-60 days to pay the full cost of the good or the service. Terms may also include discounts for paying within a certain timeframe.

Because the goods have already been sold or the service already performed, accounts receivable are classified as an asset on the company’s balance sheet because the only thing left is waiting for the cash to come in.

Companies need to have cash on hand, which is why they want to have a sustainable business model with good customers who pay their debts on time so that they can incur new expenses to expand growth.

Accounts Receivable Turnover Ratio Formula

The ratio calculates the number of times per period a company collects its average accounts receivable.

If the ratio is measured for a quarter and you get a value of 4, it means the company collects its average accounts receivable 4 times during the quarter and collects its cash relatively quickly.

The ratio by itself cannot be used as a measure of liquidity. Depending on the company, if they undertake longer projects that take longer to receive cash, you have to adjust the period to reflect this. If a customer needs 3 months to pay off a debt, you can’t measure the ratio weekly.

It also helps the company compare their ratio between periods to ensure that they’re running as efficiently as possible by ensuring they have enough cash to grow while maintaining a creditworthy customer base.

Accounts Receivable Turnover Ratio = Net Credit Sales / Average Accounts Receivable

Breaking Down Accounts Receivable Turnover Ratio formula

The formula has 2 parts to this. Although it seems straightforward, it’s easy to confuse the calculating metrics with other similar-looking metrics, which can cause miscalculations like net credit sales being confused for gross credit sales.

Besides the actual values, the timings need to be accurate as well, and all information needs to come from the period being measured since it would be hard to measure changes in sales if there was other information from previous periods being used.

1. Net Credit Sales

Net credit sales are sales where cash is collected at a later date after the sale was made. In simpler terms, the customer doesn’t have to pay the full amount upfront and may get extra time to pay the price.

Before we find the net credit sales, we need to find gross credit sales, where gross credit sales are the total amount of credit sales made without accounting for any deductions. This doesn’t give the real data. 

We must also account for any sales returns, discounts, or allowances. Discounts and allowances are reductions to the price of goods or services. 

Discounts happen when a customer makes a payment earlier than needed, so they get a discount, which is established in the given terms. Allowances happen when there’s an issue with the customer's product, so the seller gives a partial or full refund.

The formula for net credit sales is 

Gross Credit Sales - Returns - Discounts - Allowances 

It gives the actual amount of money that is owed to the company.

2. Average Accounts Receivable

It’s the average between the beginning and ending of accounts receivable for a period.

It should only cover a specific period; information between periods can’t be used. To be able to compare ratios, it has to be the same amount of time that passes. It can be days, weeks, or months, but most companies measure it in terms of quarters.

It also depends on the terms of the sale. For example, if you gave a customer 30-60 days to pay back a sale, calculating the ratio using a week wouldn’t be much use since there would be little difference on a day-to-day basis.

Example of the Accounts Receivable Turnover Ratio

Imagine there’s a store that sells clothes, and they do credit sales. At the beginning of March, they had an accounts receivable balance of $10,000, and at the end of March, they had a balance of $5,000. Their net credit sales during March were $30,000. What would be the ART Ratio?

Solution: The net credit sales are 30,000, and the average accounts receivable is 

(10,000 + 5,000)/ 2 = 7,500 

So, the ratio is 

30,000 / 7,500 = 4

This means they collected their average accounts receivable 4 times during March.

Interpretation of Accounts Receivable Turnover Ratio

Because accounts receivable is effectively an “I owe you” that a customer takes, it shows how capable a company is of collecting money.

Most receivables are due in 30, 45, or 60 days to give the customer time to acquire the cash needed to pay back the money. Depending on the customer, there may be extra terms involved, like discounts or extended terms.

The ratio helps businesses understand how quickly they’re collecting their payments and can help them influence credit policies to make sure they’re supporting business growth and adjusting their operations to do so.

It should be compared with previous periods to assess credit policies and the customer base better and ensure that the company growth isn’t negatively affected by either. 

Most companies want at least a ratio of 1.0 to ensure they collect enough average accounts receivable to match net credit sales at least once during a period so they don’t run into cash troubles.

What Does a High Ratio Mean?

It could mean one of a few things, such as: 

• A company collects its credit sales efficiently and does not give customers too much time to pay their debts. 
• They have creditworthy customers who pay off their debts on time.
• The company works on a cash basis and only recognizes revenues and expenses on its balance sheet when cash is given in hand.
• They’re also really strict on credit policies and may turn away customers who don’t meet the criteria and may lose business.
• The company may be in an industry that has high-frequency, low-value transactions (e.g., a grocery store) and has more frequent cash turnovers.

What Does a Low Ratio Mean?

It could mean one of a few things, which could also be good or bad: 

• There may be a lot of time given to customers to pay off their debts, and it may be too long.
• Bad credit policies that make the company unable to collect their debts efficiently
• Customers may not be creditworthy and may not pay off their debts near the very end. 
• The company may sell items that take a long time to put to use (e.g., if a customer buys wood and needs it transported across the country, it may take a lot of time to receive the wood, and the customer may pay the debt off only when they receive the wood).

What Affects the Accounts Receivable Turnover Ratio?

There are multiple things to consider that could affect the ratio. Depending on these things, it could change the way it’s interpreted since a high or low ratio could be either good or bad.

To thoroughly evaluate the meaning of the ratio accurately, we have to consider a multitude of factors, including:

1) The industry the company operates in

• Certain business models and sales cycles
• It depends on the type of transaction involved and the products being sold
• How expensive the item is, and how long it takes to be used
• Size of the company

2) The types of customers

• Individual customers and small retailers have quicker collections than big businesses and government entities
• Creditworthy customers

3) Nature of the credit terms

• Based on creditworthiness, some customers may have more time to pay back their debts.
• If there are discounts given to those who pay back by a certain time, then this may incentivize customers to pay back quickly and increase the ratio.
• It may be used to attract a larger number of customers or reduce the number of customers who’d pay on credit.

4) Macroeconomic conditions

• Some may not have as much money on hand during bad economic conditions and need to rely on credit more.
• Financial standing improves more during good economic conditions.

5) Seasonality

• Some businesses get a large chunk of their sales during a certain period (e.g., florists on Valentine's Day) and may change credit terms to accommodate better. 
• More lenient on credit terms when more cash is coming in

6) Geographic factors

• Cultural norms
• Applicable laws
• Average income level

Tips for Improving Accounts Receivable Turnover Ratio

Since many factors go into finding a good ratio, this also means there are multiple ways to improve it. Some solutions may work for some businesses, but there are multiple ways to tackle this issue.

Rather than changing the fundamentals of the business and its products, most businesses focus on customer-related methods to increase/decrease their ratio.

Here are some following tips to improve your ART Ratio.

1. State payment terms: If your customer doesn’t know when to pay back or how much to pay back, this can lower the ratio.
2. Offer discounts for paying back within a certain period: Some companies offer small discounts if a customer pays their debts early, incentivizing faster cash collection.
3. Remind your customers often: Customers can tend to forget their debts, which is why it’s important to follow up, especially in advance of the due date, to get better collections.
4. Set higher restrictions for credit terms: Although this may turn some customers away, it ensures the customers left are creditworthy and will pay their fees back on time.

Accounts Receivable Turnover Ratio Importance

Since there isn’t a single exact number that a company should aim for, it can be hard to figure out what ratio a company should have. It’s a general rule that it should be above 1, but depending on the circumstances listed above, there’s a wider range of acceptable ratios.

The ratio helps indicate a company’s liquidity because it calculates how efficiently a company receives cash. 

If a company incurs a lot of short-term debts, it wants to have a higher ratio because it needs to pay its debts back on time, which is dependent on its customers.

If a ratio ends up going above or beneath a company’s goal, it could signal that there’s a change that needs to be made within the business model and/or their credit policies. 

There’s a cost between making sales that won’t be paid back and losing customers who would pay back debts.

The ratio can help the company plan its long-term investments by helping it figure out how much cash it can get its hands on in a certain period. If a company struggles with cash collection, it may not be in a good position to undertake long-term projects.

Accounts Receivable Turnover Ratio Advantages

The ART Ratio has many benefits since it’s easy to calculate and provides valuable information to help indicate business health.

1. Great indicator: It doesn’t require someone to search through all of the financials to get an important indicator.
2. Track customer satisfaction: It shows how many customers are buying on credit, and it also rewards creditworthiness by adding incentives like discounts to creditworthy customers.
3. Shows credit policy efficiency: Comparison between periods makes it easy to adjust policies whenever needed to meet the company's goals.
4. Keeps track of company changes: Measuring raw numbers doesn’t keep track of creditworthiness, and it helps make sure that the credit policies in place reflect the size of the company to maintain a healthy ratio.

Accounts Receivable Turnover Ratio Disadvantages 

Although the ratio may seem simple to calculate and interpret, there are a few disadvantages that you have to keep track of while using it if you want to get the most efficiency out of it.

1. Easy to miscalculate: This error can inflate the ratio and give an incorrect interpretation.
2. It has to align: If you change your credit terms to longer terms, then you have to adjust the ratio calculation period, and it may take a few periods before you get a good understanding of the ratio.
3. Multiple factors affect the ratio: This includes the factors that were mentioned above, and these all have to be accounted for before you make goals for the company and its future.

Conclusion

The Accounts Receivable Turnover Ratio calculates how many times the average accounts receivable is collected from a company’s customers within a certain period. It’s a measure of liquidity as it measures the incoming cash flow compared to a company’s credit sales.

Most companies want to keep a general ratio of above 1, but depending on many factors like the industry in which a company operates and macroeconomic factors, a “good” ratio changes. 

The formula to calculate the ratio is 

ART Ratio = Net Credit Sales / Average Accounts Receivable for the period being calculated 

All data must come from within the period; otherwise, it’s unusable because you can’t effectively measure a company's performance.

It’s a good way to keep track of debt collection policies, make sure customers can pay back their debts on time, and make sure the company is meeting its operational goals to sustain growth.

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