What is Accounts Receivable Turnover?
Account receivable turnover ratio measures cash collection efficiency in an accounting period. The number of times receivables get converted to cash.
Accounts receivable are created in case of credit sales. Accounts receivable are current assets shown in the company’s balance sheet under the assets category. It is their high convertibility to cash or turnover, which is normally within a 1-year span, that causes them to be categorized as current assets.
Accounts receivable are a part of a company’s much larger working capital cycle and impact the company’s cash flows. The efficiency with which a company collects its average accounts receivable represents four things:
- Quality of debtors
- Short term liquidity
- Company’s credit policies
- Creditworthy customers
Investors, especially the ones who are investing in the short-term, always look for cues related to liquidity in the short term, creditworthiness, cash flow management, accounts receivable balance, credit sales, etc., amongst other factors. The cash conversion cycle, i.e., the speed with which the company can generate cash out of credit sales, impacts its pending payments, too. Thus, not just investors but creditors also look for similar cues.
Accounts receivable turnover ratio, often abbreviated as AR turnover, quantifies the frequency at which a business converts its accounts receivable into cash, which is crucial for effective working capital management, as it directly impacts the cash flow and the overall financial stability of an organization.
Significance of Accounts Receivable on Company’s Financial Health
The state of the company’s receivables serves as a barometer of the company’s proficiency in managing and collecting credit sales.
Cash Flow Management
The company’s accounts receivable turnover directly impacts cash flow management. A company collects cash from the accounts receivable, and it is helpful to meet short-term obligations like paying creditors, buying raw materials, paying creditors early to get discounts, reinvesting in operations, etc.
A high AR turnover ratio will translate to healthier cash flow due to an efficient cash collection system. A low AR turnover ratio will translate to a struggling cash collection, where the company may have to resort to accounts receivable financing (AR Financing) or regularly depend on bills of exchange and bank overdrafts.
Impact on Overall Working Capital Cycle
The working capital cycle starts from the time inventory is purchased to when cash is collected from receivables. The importance of the working capital cycle can be gauged from the fact that it is needed to run the routine operations of the company/ factory; without it, the company may find it difficult to fund daily operations and close factories for some months to save capital.
You must have heard about cost-cutting or downsizing during a recession or periods of low working capital.
A high accounts receivable turnover implies a shorter cash collection cycle, hinting that the company is more adept at converting its receivables into cash. With a healthier cash flow, the working capital cycle functions seamlessly, and the company does not need to depend on financing options, thus saving the cost of interest payments, bank fees, etc.
In 2018, Tesla was facing a cash crunch and missed production deadlines for Tesla Model 3. The company faced a downgrade from Moodys and was under pressure incase the creditors starts demanding payments, then it could lead to desperate situation.
Impact on the Company’s Debtors Profile
A high AR turnover ratio indicates stringent credit policies, while the sales process attracts creditworthy customers. A low AR turnover ratio indicates lenient credit policies, potentially attracting customers with weaker credit profiles and increasing the risk of bad debts.
Analyzing the AR Turnover Ratio also provides insights into the company’s debtor profile. A higher ratio often indicates that a company’s credit policies are stringent and effective, attracting creditworthy customers. It suggests that the company is successful in managing customer credit and collecting dues promptly. Conversely, a lower ratio may signal
The AR Turnover Ratio acts as an indirect tool for assessing the credit quality of a company’s clientele and the risk associated with its receivables.
Company’s Collection Process
The accounts receivable turnover ratio is important when the credit sales constitute the bulk of a company’s revenue. The AR Turnover Ratio sheds light on the efficacy of a company’s collection process.
The credit and collection policies of a company comprised of the following:
- Credit and payment terms.
- Invoicing procedure.
- Follow-ups and due dates.
- Ways of handling late payments.
- Any discounts or offers given for prompt payments.
The company with a good accounts receivable turnover has robust strategies in place for timely invoicing, assertive follow-up on overdue accounts, and successful resolution of payment issues.
The efficiency in collections not only accelerates cash inflows but also minimizes the likelihood of accumulating bad debts, thereby safeguarding the company’s financial health.
On the other hand, a lower ratio may highlight inefficiencies or gaps in the collection process, which could be due to delayed invoicing, inadequate follow-up on receivables, or lenient credit policies leading to extended credit terms. Such inefficiencies can tie up funds in receivables for extended periods, thereby straining the company’s cash reserves and potentially impacting its ability to fund operations or capital expenditures.
Factors Affecting Accounts Receivable Turnover
Accounts Receivable (AR) is a current account asset on a company’s balance sheet reflecting the credit sales yet to be collected. As in accrual accounting, the revenue is already registered for accounting purposes, but cash is still pending to be recovered. The following are the factors affecting a company’s accounts receivable turnover:
Company’s Credit Policy
A stringent credit policy where there are credit checks and guidelines before allowing credit sales usually leads to low accounts receivable turnover because the credit is given to highly creditworthy customers.
In the case of lenient policies, there increased sales volume but also led to a higher amount of outstanding receivables, potentially increasing the risk of bad debts.
Customer Payment Behavior
Monitoring long-term customer payment trends is helpful in managing accounts receivables. The payment behavior of customers reflects that customers who consistently pay on time reduce the average accounts receivable balance, improving the AR turnover ratio. Whereas, customers with a history of late payments or defaults can increase the accounts receivable balance, indicating potential cash flow issues.
Do you know American Express (AMEX) uses AI and algorithms to detect customer behavior and avoid any fraud?
Economic Conditions
During an economic downturn/ crisis or recession, customers may delay payments or default, resulting in inflating the accounts receivable balance and adversely affecting the company’s cash flow.
In a booming economy, the payments are received faster, and the extra sales cover up any shortcomings or inefficiencies in the collection cycle, the companies are often lenient in extending credit with easy payment terms.
Internal Collection Processes
The efficient internal collection process comprises effective invoicing procedures, regular follow-ups, and efficient handling of disputes, which can lead to timely collections. Inefficient processes, including delayed invoicing or lack of follow-up, can result in an increased receivable balance and a lower AR turnover ratio.
Industry Practices
Industries with longer project lifecycles may have inherently longer receivable periods compared to those with quick turnover products or services. The average collection period is aligned with the industry standards.
The average collection period will be much different in a steel or manufacturing industry as compared to retail, food, white goods, services, etc.
The companies must strategically manage their credit policies, monitor customer payment behaviors, adapt to economic conditions, streamline internal collection processes, and understand industry-specific practices to maintain a healthy accounts receivable balance and ensure robust financial health.
Accounts Receivable Turnover Ratio
The accounts receivable turnover ratio computes the number of times or duration within which a business is able to collect its accounts receivables. Thus, it reflects the efficiency of a company’s credit and collection policies by indicating how often or how quickly the business turns its receivables into cash.
The Accounts Receivable Turnover Ratio can be calculated in two formats:
- As a frequency or
- In terms of number of days.
Calculation in Times
The accounts receivable turnover ratio, when measured in frequency, is calculated by dividing net credit sales by average account receivables:
Accounts Receivable Turnover Ratio Formula = Net Credit Sales/ Average Accounts Receivable
Here,
Net Credit Sales = Credit Sales minus sales returns and sales allowances.
Net Credit Sales = Gross Credit Sales – Sales Return – Sales Allowances
(Note: It is crucial to include only credit sales since cash sales do not contribute to accounts receivable.)
Average Accounts Receivable Formula = (Opening Accounts Receivable Balance + Ending Accounts Receivable Balance)/ Divided by 2
Calculation in Days
Learn to Calculate Accounts Receivable Turnover in Days or Days Sales Outstanding (DSO).
Days Sales Outstanding = Average Accounts Receivable/ (Net Credit Sales / 365)
Day sales outstanding indicates the average number of days taken by the company to collect the outstanding receivables i.e., the credit sales. A lower DSO suggests quicker collection, enhancing the company’s cash flow.
In the above calculations, the average accounts receivables was used. It is the average amount of credit that is extended to the customers, which is still outstanding and yet to be collected.
Learn to Calculate Accounts Receivables Turnover
Example 1
Let’s assume Company A has the following financial data for a year:
- Total Sales: $500,000
- Credit Sales: $400,000
- Sales Returns: $20,000
- Opening Accounts Receivable Balance: $50,000
- Ending Accounts Receivable Balance: $70,000
First, calculate the Net Credit Sales:
Net Credit Sales = Credit Sales −Sales Returns
= $400,000 − $20,000 = $380,000
Calculating Average Accounts Receivable:
Average Accounts Receivable Formula = (Opening Balance + Ending Balance) divided by 2
= ($ 50,000+ $ 70,000) divided by 2 = $60,000
Accounts Receivable Turnover Ratio Formula = Net Credit Sales divided by Average Accounts Receivable
= $380,000 divided by $60,000 ≈ 6.33 times.
Company A has accounts receivable turnover rate of approximately 6.33 times a year, indicating a relatively efficient collection process.
Example 2
Consider Company B with the following data for a particular accounting period :
- Total Sales: $750,000
- Gross Credit Sales: $600,000
- Sales Returns: $30,000
- Opening Accounts Receivable Balance: $80,000
- Ending Accounts Receivable Balance: $100,000
Computing Net Credit Sales: $ 600,000 − $ 30,000 = $ 570,000
Average Accounts Receivable = $ 80,000 + $ 100,000 divided by 2 = $ 90,000
Using Accounts Receivables Turnover Formula = Net Credit Sales/ Average Accounts Receivable
= $570,000 divided by $90,000 = 6.33 times.
Days Sales Outstanding (DSO) or Receivable Turnover Formula in days = 365 divided by Turnover Ratio
= divided by 6.33 ≈ 57.66 days.
Company B’s receivable turnover in days is approximately 57.66 days i.e. days to collect its receivables, suggesting a moderate collection pace.
Accounts Receivable and Decision-making
In addition to the accounts receivable turnover ratio, there are other metrics that must be considered in management accounting to forecast, analyze, manage, and predict the cash collection efficiency and likelihood of defaults and bad debt.
It is recommended to consider these metrics for managerial decision-making in addition to the accounts receivable turnover ratio:
Bad Debt to Sales Ratio: measures the proportion of bad debts, i.e., uncollectible debts, against total sales, indicating the impact on overall revenue.
Debtor Turnover ratio: This is another name for the accounts receivable ratio.
Efficiency ratio: Often used in evaluating the internal operations efficiency of a business. The efficiency ratio assesses a company’s ability to use its assets and manage its liabilities effectively in generating income.
Tips to Improve Accounts Receivable Cycle
Optimizing accounts receivable collection includes a combination of timely invoicing, regular follow-ups, reminding on and before due dates, regular analysis, cash discounts, favoring upfront payment terms, strong customer relationships, penalties, multiple payment options, etc.
There are multiple strategies that a business can implement as per industry standards and commercial feasibility to optimize the accounts receivable turnover ratio and enhance financial stability.
- Timely and accurate invoices with regular reminders help to increase the likelihood of getting paid early, thereby reducing average accounts receivables.
- Use automated invoicing systems like EBetterBooks to reduce any errors and delays, schedule sending invoices and payment reminders, and create recurring invoices.
- Before extending credit to any customer, conduct a thorough credit check. You can get the details from a customer’s credit score. Additionally, regularly revise credit limits, discounts for cash payments, credit policies, etc.
- Offering multiple payment options like credit cards, online, electronic fund transfer, PayPal, etc., provides convenient and friendly payment platforms that increase payment probabilities and help improve the accounts receivable turnover ratio.
- Address disputes swiftly, and if needed, use dedicated collection agencies or maintain a separate department for the collection of outstanding debt and receivables.
- Offer cash payment discounts or cash discounts, early payment discounts, etc., to incentivize early payment, thereby reducing the accounts receivable balance.
- Identify customer payment trends and behavior to identify delinquent customers or to identify errors in the invoicing process.
Accounts Receivable Turnover and Financial Modeling
Financial modeling is a process to mathematically evaluate the impact of business decisions or investments by making different scenarios or models. It involves using historical data, assumptions, and forecasts to build dynamic financial statements and evaluate the potential impact of various financial decisions or scenarios.
The Accounts Receivable Turnover Ratio serves as a significant indicator of a company’s liquidity and operational efficiency and impacts a company’s cash flow and credit management, guiding strategic decision-making and forecasts.
Integration in Cash Flow Projections
Financial analysts build financial models to analyze past and current accounts receivable turnover ratios. These models help to project future cash flows and decide upon the timing of other cash flows vis a vis the pace at which a company collects receivables. It helps to plan liquidity and working capital management.
Impact on Balance Sheet Forecasts
The accounts receivable turnover ratio in financial modeling is used to forecast future cash flows and their impact on short-term worthiness. The accuracy of balance sheet forecasts should be realistic and take into account the changes in working capital. The degree of accuracy in the estimation reduces the variance and facilitates data-based decision-making.
Credit Policy Analysis
Financial models can simulate various scenarios, adjusting credit terms and policies to see how they might affect the receivable turnover. This analysis is crucial for determining optimal credit terms that balance sales growth with efficient cash collection.
Risk Assessment
The accounts receivable turnover ratio is also instrumental in assessing credit risk, where a lower accounts receivable turnover might indicate potential cash flow problems and higher credit risk, which can be factored into risk assessment models. This insight is vital for both internal management and external stakeholders, such as investors and creditors, who are keen on understanding the risk profile of the company.
Advantages
- Liquidity Assessment: The accounts receivable turnover ratio highlights the liquidity position of a company. A high accounts receivable turnover signifies an efficient collection of outstanding receivables, resulting in a positive cash flow.
- Credit Policy Evaluation: The accounts receivable turnover ratio is a single-point metric that highlights the effectiveness of the company’s credit policies. A high accounts receivables turnover ratio represents stringent credit policies and a strong and creditworthy customer base, while a low turnover ratio signifies a lenient or conservative credit policy where there is ample scope for optimization.
- Investor Attractiveness: The accounts receivables turnover ratio helps the investors gauge the company’s efficiency in managing receivables, influencing investment and credit decisions.
- Benchmarking Tool: The accounts receivables turnover ratio acts as a benchmark for intra-industry/ sector comparison with peers and competitors to identify best practices.
- Financial Health Indicator: The accounts receivable turnover ratio provides insights into the company’s finances, particularly its ability to convert receivables into cash, which is needed for meeting its short-term obligations.
Limitations
- Business Cycle Variations: The change in the business cycle is not fully represented, as there can be seasonal variations in sales.
- Focus on Credit Sales: With the accounts receivable turnover ratio focusing on the credit sales, the cash sales get neglected. If a company incurs cash sales as a majority of revenue, then this ratio is not helpful for any decision-making.
- Inconsistencies Due to Credit Policy Changes: If there are changes in the credit policy, then comparing the accounts receivable turnover ratio with historical data is not possible.
- Average Accounts Receivable Calculation: Fluctuations in receivable turnover can skew the whole ratio. Also, if a company uses gross sales instead of net sales, then this can misrepresent the state of finances.
- Not a Standalone Indicator: To assess the short-term liquidity condition of the company, it is recommended to include other ratios like debtor’s turnover ratio, efficiency ratio, etc.
- Potential for Inflation: A company might temporarily boost its sales at the end of a financial period through aggressive credit terms, superficially enhancing the turnover ratio.
Conclusion
A business can be big or small, it is the cash flows that keeps it running. There have been instances where businesses with robust assets in terms of lands and buildings collapsed overnight due to a cash crunch, i.e., lack of liquidity. Managing the cash flows is crucial as you can gauge the fact that final accounts of a company also has a statement dedicated to cash payments and incomes (Cash flow statement).
All commercial businesses must keep a sharp eye on the accounts receivable turnover ratio as it measures the incoming revenue for the company. It is recommended to calculate it even on a quarterly basis and not to wait for yearly analysis and take corrective measures when needed.