The Accounts Receivable Turnover ratio (AR T/O ratio) is an accounting measure of effectiveness.
It is also known as the Debtor’s Turnover ratio, and we use it to gauge how effectively the company manages credits they extend to customers and collection.
We calculate the ratio by dividing net sales over the average accounts receivable for the period.
Managers often pay more attention to sales and margins and not enough attention to their accounts receivable and collection. We can’t run a company on low cash flow, so it’s vital to have efficient debt management.
Generally, we prefer a higher ratio, which means the business is more efficient at collecting due amounts from its clients.
What is the Accounts Receivable Turnover Ratio
The Accounts Receivable Turnover ratio is a measure in accounting that enables the business to quantify its ability to manage credit collection effectively.
By holding trade receivables, we are extending interest-free loans to our customers. The ratio helps us analyze how well we manage the following debt collection. We can calculate the measure on an annual, quarterly, or monthly basis, depending on the business and our needs.
We track the ratio over time to analyze its development and spot patterns.
Calculating the AR Turnover Ratio
We calculate the metric via the following formula:
We start with credit sales for the period. These exclude cash sales and other sales where the company did not extend credit to its customers.
Next, we deduct any returns or doubtful debt allowances. Doing so leaves us with Net Sales.
Average Accounts Receivable
These include the average amount that customers owe to the company. We calculate it as the average amount between the opening and closing balances for a period corresponding to net sales.
In specific circumstances where there are significant fluctuations near the beginning or end of the period, we might do a weighted average calculation.
Now that we have the Net Sales and the Average Accounts Receivable, we divide them and arrive at the Accounts Receivable Turnover Ratio.
Accounts Receivable Turnover in Days
Another metric we can look at is the representation of the ratio in days.
This metric shows the average number of days it takes customers to pay their debts. When calculating the Accounts Receivable Turnover in Days, we need to align the Days in period with our AR T/O calculation period.
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The Accounts Receivable Turnover Ratio helps us evaluate the company’s credit policies. Credit sales exclude cash sales, as they do not generate receivables. Thus, the ratio has a direct link to collection from clients. The better collection generally equals a higher rate.
The metric shows the effectiveness with which the business manages credit and debt collection.
A higher ratio indicates we are turning over trade receivables faster, and customers settle debts more quickly.
It can mean that clients settle their dues timely, which increases the company’s positive cash flow. This, in turn, helps the business to pay its payroll and debts to suppliers quickly. Another reason for a high ratio is the effectiveness of the collection method the company employs.
A fair screening process that helps the business identify customers whit potential delays in payment also benefits the company as it helps us minimize the doubtful and bad debt.
We can also have a higher ratio if management has implemented strict credit limits, meaning clients will have to settle their amounts before placing new purchase orders. A high measure can also result from doing a large portion of the business on a cash basis.
A higher ratio is usually better, but we need to make sure we have a balanced value. If we have a highly aggressive collection policy, this will lead to an even higher ratio but push clients away. Potential customers with a slightly worse credit may not pass such an approach, resulting in missed business opportunities.
A low ratio indicates ineffective collection. This may be due to poor collection policies or extending too much credit to clients, leading to bad and uncollectable debt, which harms cash flows. If customers struggle to make payments because we overextended credit to them, they may place fewer purchases in the future. It can indicate we work with clients that are not creditworthy.
A lower metric can also indicate additional problems with the business. Suppose we struggle with timely deliveries, ship out the wrong products, or have low manufacturing quality. In that case, this will result in replacements, canceled orders, and will hurt our Accounts Receivable Turnover Ratio.
Using the Ratio in Financial Analysis
The ratio can be a critical KPI to management in planning and decision making. Therefore, it’s a great idea to track the rate over time and identify opportunities to improve our policies and processes. Doing so may then have a positive impact on the company’s bottom line.
We can also use the Accounts Receivable Turnover Ratio in cashflow estimations, where we can adjust expected cash inflow and better plan expenses.
Figuring out and addressing issues with collection to improve cashflows will also leave us with more resources to reinvest in growing the business.
Many loans use receivables as collateral, and lenders often look at this metric when deciding if they are willing to work with our company. Investors would also consider the ratio when comparing similar investment opportunities, showing a preference for businesses offering a better measure.
The ratio is useful in working capital management. A better measure ensures the business will need less investment in working capital.
We can also correlate the metric to earnings on a per-period basis to identify how it influences profitability.
We should consider companies within the same industry with similar business models and capital structures when we perform benchmark analysis.
It is critical to remember that some companies may use total sales instead of net sales in their calculation, which will inflate the metric. This may not be deliberate, but we should consider how companies arrive at their ratio and adjust our analysis accordingly.
Improving the Ratio
The first step in improving our ratio is to identify the source of our problems.
There are many ways to improve the metric.
We can offer an early-payment discount to our clients if they settle their dues early.
Accurate and timely billing to clients
If we employ an invoicing system or a CRM linked to our ERP/Accounting software, it can help provide clients with detailed invoices.
Clear payment terms in both contracts and invoices
We have to remember it’s OK to add late payment fees, as long as we communicate those from the start. Having a detailed outline of our payment terms is critical for having a good relationship with our clients. We can offer better terms to customers willing to work with advance payments.
Various payment options
Giving clients ample ways to settle their dues will make it easier for them to pay. This can lead to better collectability of the company’s receivable.
Keep clients happy and invest in customer relations
To achieve this, we can arrange for check-in calls or e-mails and other small gestures. Open and honest communication is crucial to building trust and excellent client relationships.
As with any ratio within financial analysis, the Accounts Receivable Turnover ratio also has some limitations. It won’t help us identify potential bad receivable accounts of customers. The only aid we get lies in spotting some general trends.
Clients that pay right away can skew the metric and make it misleading, as we calculate it based on averages. Conversely, customers taking too long to settle their dues will also impact the viability of the ratio.
The Accounts Receivable Turnover ratio has some caveats. It is not perfect, but it gives us a useful assessment of our collection policies’ strength and how effective the business is in accounts receivable management.
If we have an abnormal starting or ending balance, this can also render the measure useless. We may consider a weighted average balance instead and review our Trade Receivables Ageing report to ensure our ratio properly represents our collectible amounts.
Example Accounts Receivable Turnover Ratio Analysis
Let’s explore the ratio and look at how it can be helpful for the company.
First, we need to look at our income statement to get our sales. As we don’t have information on net sales, we will further adjust these in our calculation.
Next, we look at the balance sheet to extract the trade receivables’ balances for each year.
Starting our Accounts Receivable Turnover Ratio calculation, we first need to adjust sales. As we don’t have detailed data on returns and doubtful debt allowances, we can use the average percentages we know from experience. These are 2.1% for returns and 1.7% for allowances. Subtracting these from the revenue will give us Net Sales.
As we advance, we can use the closing balance of the previous period as the opening balance for the current period and calculate the Average Accounts Receivable value. For FY 2016, we have no opening balance, so we use only the closing balance for our calculation.
Now that we have calculated the Accounts Receivable Turnover Ratio for each period, we can plot it and look into the development over the five years. We can also look at the AR Turnover Days to see how much it takes the business to collect on average. Comparing this to our average credit terms will indicate whether our customers are paying late or not.
There are some fluctuations in the ratio over time. However, the overall trend is going downwards, indicating the business is facing some challenges with debt collection. We need to further look into the reason behind such a development. Once we have identified the cause, we can implement one of the various actions to improve our Accounts Receivable Turnover ratio.
The Accounts Receivable Turnover ratio is a useful metric in financial analysis. It can help us with working capital and cash flow management and improve trade receivables and debt collection. The ratio is mostly easy to calculate, making it a vital part of our financial analysis toolkit.
Investors, lenders, and financial analysts use it to understand better how the business manages extended credit and subsequent collections.
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