What is Accounts Receivable Turnover? Formula and Meaning

1. What is receivable turnover?

Receivables turnover is a measure of how many times a business converts its receivables into cash in a given period of time. This is an important indicator to evaluate the efficiency of debt collection from customers.

Businesses often calculate receivable turnover monthly or quarterly to promptly assess the debt collection situation. In addition, annual calculations help businesses have an overview of the debt collection situation during the year and adjust strategies for the following years.

2. Formula for calculating receivable turnover

 

How to calculate receivable turnover:

 

Accounts receivable turnover = Net credit sales / Average accounts receivable balance

 

In there:

 

Net credit sales: Total revenue generated during the period that has been collected in cash.

 

Average receivable balance: Average of receivables at the beginning and end of the period, divided by 2.

3. Meaning of receivables turnover ratio

Receivables turnover evaluates a company's credit policy, an important factor affecting sales, profits, and solvency. Appropriate credit policy attracts potential customers, helping to increase sales and profits.

A high receivables turnover ratio indicates that the company is collecting debts effectively, improving cash flow to pay short-term debts and invest in business. Conversely, a low ratio may be due to allowing customers to pay late. This reduces cash flow efficiency and increases the risk of bad debt, affecting the company's ability to pay.

4. What is a good receivables turnover ratio?

The determinant of receivables turnover ratio depends on many factors. Holding on too tight can negatively affect the business, while collecting debts too loosely leads to unstable cash flow, making it easy to face the risk of cash flow shortage.

In general, a high receivables turnover ratio is generally better. This indicates that customers are paying on time and debts are being collected properly, indicating a tight balance sheet, stronger credit capacity, and balanced asset turnover.

The ideal AR (Accounts Receivable) turnover ratio depends on your industry. A high AR turnover ratio indicates that a business is cautious about extending credit and aggressive in collecting debts.  

A high AR ratio is beneficial to a company's cash flow, but can affect the quality of customer service. A high ratio also indicates that a company's customers are of high quality or that the company operates primarily on a cash basis.

In some cases, a lower ratio can help you get more customers. However, a persistently low ratio may indicate that AR is being poorly managed or that the company is extending credit too easily. It could also mean that the business serves a high-risk customer base or has been affected by a major economic event.

A consistently low receivables turnover ratio indicates that a company's invoice terms are too long and that its credit policy needs to be controlled. This sometimes happens when sales teams extend credit terms to close a deal.

Finally, the time value of money principle states that the longer it takes to collect credit sales, the more money a company loses. Therefore, a low AR turnover rate is considered detrimental to a company’s financial health. Periodically comparing your AR turnover rate to that of your industry competitors will provide a more meaningful analysis of performance than relying on a single number.

5. Some ways to improve receivable turnover ratio

If your AR turnover ratio is low, adjust your credit and collection policies immediately to maintain positive business cash flow. Here are some tips to help you improve your receivable turnover ratio:

• Invoice Regularly and Accurately: Make sure invoices are sent out promptly and without errors. Use accounting software to automate this process, avoid errors, and minimize payment delays.
• Offer multiple payment methods: Allow customers to pay via multiple methods such as credit card, bank transfer or check to increase the likelihood that they will pay faster.
• State payment terms clearly: Payment terms must be clearly stated in all agreements, contracts and invoices so that customers understand and comply.
• Payment reminders: Set up automatic reminders and notifications to track payments. Be proactive in reminding but don't annoy customers.
• Consider early payment discounts: Encourage customers to pay early by offering discounts. This is an effective strategy to improve cash flow.

Managing and optimizing receivable turnover helps businesses improve cash flow and increase financial stability. By applying effective management strategies, businesses can minimize risks, optimize debt collection processes and ensure sustainable development.