- What is Accounts Receivable Turnover Ratio?
- Accounts Receivable Turnover Ratio Formula
- How to Calculate Accounts Receivable Turnover Ratio?
- Interpretation Accounts Receivable Turnover Ratio
- Benefits of Using Accounts Receivable Turnover Ratio
- Limitations of Using Accounts Receivable Turnover Ratio
- How to Increase Accounts Receivable Turnover?
What is Accounts Receivable Turnover Ratio?
The accounts receivables turnover ratio refers to an accounting ratio that measures how well a company collects its accounts receivable. This ratio assesses how well a company manages and uses the credit it gives to consumers, as well as how efficiently that debt is recovered or paid. A company that is efficient has a higher accounts receivable turnover ratio than one that is inefficient. This metric is frequently used to evaluate companies in the same industry to see how well they compare to their competition.
Accounts Receivable Turnover Ratio Formula
The formula for the Accounts Receivable Turnover Ratio is:
Accounts Receivable Turnover Ratio – Net Credit Sales / Average Accounts Receivable
Average Accounts Receivable = (Accounts Receivable at the Beginning of the Year + Accounts Receivable at the End of the Year) / 2
Net Sales = Total Credit Sales – Sales Returns – Sales Discounts
Debtors or Accounts Receivable Turnover in Days = (1 / Debtors or Accounts Receivable Turnover Ratio) * 365
How to Calculate Accounts Receivable Turnover Ratio?
To calculate the accounts receivable turnover ratio , you need to first calculate the net sales and average accounts receivable.
The following is an example of how to calculate the accounts receivable ratio:
|Total Credit Sales||Rs 5,00,000|
|Total Discounts||Rs 20,000|
|Sales Returns||Rs 60,000|
|Accounts Receivable as on 1st April 2021||Rs 60,000|
|Accounts Receivable as on 1st March 2021||Rs 1,00,000|
|Average Accounts Receivable(Accounts Receivable at the Beginning of the Year + Accounts Receivable at the End of the Year) / 2||Rs 80,000(Rs 60,000 + Rs 1,00,000) / 2|
|Net Credit SalesTotal Credit Sales – Sales Returns – Discounts||Rs 4,20,000Rs 5,00,000 – Rs 60,000 – Rs 20,000|
|Accounts Receivable Turnover RatioNet Credit Sales / Average Accounts Receivable||5.25Rs 4,20,000 / Rs 80,000|
|Accounts Receivable Turnover (Days)||69.52 days(365 / 5.25)|
Recommended Read: Portfolio Turnover Ratio
Interpretation Accounts Receivable Turnover Ratio
High Accounts Receivable Turnover Ratio
The accounts receivable turnover ratio is a financial and operational efficiency statistic that measures a company’s financial and operational performance. A high ratio is preferable since it implies that the company’s accounts receivables are collected on a regular and efficient basis. A high accounts receivable turnover also shows that the business has a credible customer base that pays its debts without any delay. Higher ratio may also indicate that the company has a conservative credit policy, such as net-20 or even net-10 days.
It can also indicate that a business is cautious about providing credit to its consumers. Furthermore, a credit policy that is excessively strict may drive away new buyers. Customers may then conduct business with competitors who can provide them with the credit they require. If a business loses clients or has poor development, it may be beneficial to relax its credit policy in order to boost sales, even if it means a lower accounts receivable turnover ratio.
Low Accounts Receivable Turnover Ratio
A low accounts receivable turnover ratio indicates that the collection mechanism at the organization is ineffective. This could be a result of the company offering credit terms to consumers who are not creditworthy but are having financial difficulties.
A low ratio may imply that the business is extending its lending policy for an excessive amount of time. It can be seen in earnings management when managers give a very extended credit policy in order to drive more sales. Because of the time value of money, the longer it takes a firm to collect on its credit sales, the more money it effectively loses, or the less valuable the company’s sales become. As a result, a low or deteriorating accounts receivable turnover ratio is seen as a negative for a business.
Benefits of Using Accounts Receivable Turnover Ratio
- The ratio shows how long it takes the company to convert credit transactions to cash. This allows the company to plan ahead of time to ensure a speedy turnaround of credit transactions into cash.
- Non-payment of dues by consumers causes businesses to lose a lot of money. With the help of this ratio, the company may better manage the number of credit sales and give credit sales to its most loyal and regular clients, resulting in fewer write-offs and bad debts.
- Based on the ratio, the company may decide to tighten up its existing credit policies in order to avoid issues like cash flow problems or clients defaulting on payments.
- The time it takes to recover an outstanding debt will be reduced as a result of the improved credit policies. As a result, cash inflows will improve as well.
Limitations of Using Accounts Receivable Turnover Ratio
The receivables turnover ratio, like any other indicator used to assess a company’s effectiveness, has limits that each investor should be aware of.
When determining turnover ratios, companies consider total sales rather than net sales. This has the potential to exaggerate the results. Investors should learn how a company determines its ratio, even if it isn’t done on purpose to deceive them. Another option is for them to calculate it on their own.
Throughout the year, accounts receivable fluctuate considerably. This is frequently the case with seasonal businesses. These companies are likely to experience periods with large receivables and a low turnover ratio, as well as times with fewer receivables that are easier to manage and collect. Hence, an average of opening and closing accounts receivable might inflate or deflate the results.
If an investor selects a starting and endpoint for computing the ratio arbitrarily, the ratio may not reflect the company’s effectiveness in extending and collecting a debt. As a result, while computing the average accounts receivable, the beginning and ending figures should be carefully determined to appropriately reflect the company’s performance. To smooth out any seasonal gaps, investors might use an average of accounts receivable from each month over a 12-month period.
How to Increase Accounts Receivable Turnover?
- To receive payments on time, send professional invoices with accurate facts to the clients/customers. Invoicing clients on schedule is another strategy that can aid with faster receipt of dues.
- Customer satisfaction is critical to the success of any organization. Building meaningful and long-term relationships with clients can go a long way toward ensuring that they make timely payments. Customers who are happy and satisfied are more likely to pay when asked.
- Offering customers a choice of payment methods typically results in a win-win situation. The customer has the option of choosing the most convenient manner, and the company can collect debts more quickly.
- Send a gentle reminder for dues by email, phone call, or text. It aids in the development of consumer relationships while also ensuring prompt payment.