WHAT IS THE ACCOUNTS RECEIVABLE TURNOVER FORMULA?  

The accounts receivable turnover ratio is a financial metric used to measure the efficiency of a company’s collection of its outstanding customer invoices. This ratio indicates how many times a company can collect its average accounts receivable balance during a specific period, typically a year. The formula is also known as ‘debtors turnover ratio formula’ and ‘days receivable formula’.  

HOW TO CALCULATE ACCOUNTS RECEIVABLE TURNOVER RATIO FORMULA  

The formula for calculating the accounts receivable turnover ratio is:  

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

where:  

• Net Credit Sales is the total sales made on credit during the period, minus any returns, discounts, or allowances.  
• Average Accounts Receivable is the average amount of money owed to the company by its customers during the period, usually calculated as the sum of the beginning and ending accounts receivable balances divided by 2.  

To see how the accounts receivable turnover ratio formula functions in real life, here’s an example:  

Andy runs a busy plumbing business. With a couple of branches, it’s more than just a one-man-band. The business had $500,000 in credit sales during the year and had an average accounts receivable balance of $50,000 during that same period. To calculate the accounts receivable turnover ratio for the business, we would use the following formula:  

Accounts Receivable Turnover Ratio = Credit Sales / Average Accounts Receivable  

Accounts Receivable Turnover Ratio = $500,000 / $50,000  

Accounts Receivable Turnover Ratio = 10  

This means that the plumbing business had an accounts receivable turnover ratio of 10 times during the year. In other words, the average accounts receivable balance was collected 10 times over the course of the year.  

To put this into context, if the business operates on a net 30-day payment term, a turnover ratio of 10 means that the business has an average collection period of three days (30 days divided by 10). 

WHY IS THE AR TURNOVER RATIO FORMULA IMPORTANT?  

The resulting ratio represents the number of times per year that a company collects its average accounts receivable balance. A higher accounts receivable turnover ratio indicates that a company is collecting its outstanding customer invoices more frequently and efficiently. A lower ratio suggests that the company may be experiencing difficulties in collecting its accounts receivable.  

It is important to note that a high accounts receivable turnover ratio may also indicate that a company has very strict credit terms or may be losing potential sales due to overly stringent credit policies. Therefore, it is important to interpret the accounts receivable turnover ratio in the context of other financial metrics and the company’s overall business strategy.  

WHAT ROLE DOES THE TURNOVER CALCULATION PLAY IN FINANCIAL REPORTING?  

The accounts receivable turnover ratio formula is an important financial reporting tool as it provides insight into a company’s collections efficiency and the state of a company’s accounts receivable.  

The accounts receivable turnover ratio is typically included in a company’s financial statements, such as the income statement and balance sheet, as well as in financial reports and presentations. This ratio provides insight into how quickly a company can collect its outstanding customer invoices and is often used by investors and creditors to evaluate a company’s creditworthiness and liquidity.  

The accounts receivable turnover ratio can be compared to industry benchmarks and historical trends to assess a company’s collections efficiency over time. This information can be used by stakeholders to make informed decisions about investing in or lending to the company. 

LIMITATIONS OF THE ANNUAL TURNOVER CALCULATION  

While the accounts receivable turnover ratio is a useful tool for analysing a company’s collections efficiency, it is important to note that there are some limitations to this metric. Some of the limitations of the accounts receivable turnover ratio include:  

• It does not consider the credit policy: The accounts receivable turnover ratio does not consider the credit policy of the company, such as the credit terms or credit limits. A company with a strict credit policy may have a high turnover ratio but may also miss out on potential sales which could ultimately impact cash flow. 
• It only considers one period: The accounts receivable turnover ratio only reflects the collections efficiency for a single period, which may not provide a complete picture of a company’s collections performance or bad debt.  
• It may be affected by seasonality: If a company’s sales or collections are affected by seasonality, the accounts receivable turnover ratio may not accurately reflect the overall collections efficiency.  
• It may not reflect the quality of the accounts receivable: The accounts receivable turnover ratio does not consider the quality of the accounts receivable. A high ratio may be due to many small accounts that are paid quickly, while a low ratio may be due to a few large accounts that are slow to pay.  
• It does not provide information on the collection process: The accounts receivable turnover ratio does not provide any information on the collection process, such as the effectiveness of the collection department or the actions taken to collect overdue accounts.  

Overall, while the accounts receivable turnover ratio is a useful tool for analysing a company’s collections efficiency, it should be used in conjunction with other financial metrics and in the context of the company’s overall business strategy. 

HOW CAN YOU IMPROVE YOUR ACCOUNTS RECEIVABLE TURNOVER RATIO? 

There are several strategies that a business can implement to improve their accounts receivable turnover ratio and increase their collections efficiency. Some of these strategies include: 

• Review and revise credit policies: A business can review and revise their credit policies to ensure that they are providing credit to customers who are likely to pay on time. This may involve establishing credit limits, payment terms, and credit checks for new customers. 
• Invoice promptly and accurately: A business should invoice customers promptly and accurately to ensure that there are no delays in payment due to incorrect or late invoicing. This may involve automating the invoicing process and ensuring that invoices are sent out as soon as possible after the sale. 
• Offer incentives for early payment: A business can offer incentives, such as discounts or extended payment terms, for customers who pay their invoices early. This can encourage customers to pay more quickly and reduce the number of outstanding invoices. 
• Follow up on overdue invoices: Businesses should have a process in place to follow up on overdue invoices. This should include sending reminder emails and making phone calls to customers who are behind on payment. Automating your collections process, from pre-reminders through to payment reconciliation and reporting can have a significant impact in reducing late payments from customers. 
• Consider outsourcing collections: A business may also consider outsourcing their collections process to a third-party collections agency or a dedicated internal collections team. This can help to free up internal resources and ensure that collections are being handled effectively and efficiently. 

If you’ve calculated your accounts receivable turnover ratio and it’s looking a little low, talk to our team about automating your collections process with CreditorWatch Collect. CreditorWatch Collect is easy to use, saves you hours on manual AR tasks and gets you paid faster.