Accounts Receivable Turnover Ratio: Definition & Formula
The accounts receivable turnover ratio is a formula that measures the efficiency of a company’s credit and collection efforts. Essentially, it helps businesses evaluate how effectively they are managing outstanding debts.
Routinely evaluating your business’s accounts receivable turnover ratio can make it easy to identify potential issues with your business’ credit policies. In this blog post, we will explore the definition and formula of the accounts receivable turnover ratio formula in detail.
How AR Turnover Ratios Work
The AR turnover ratio measures your company’s efficiency when collecting outstanding balances while extending credit. It centers around how many times you convert your receivables into cash within a specific time frame — usually monthly, quarterly, or annually.
Imagine that you own a logistics brokerage company and you’re running a load of cargo from New York to California on behalf of Customer A. Depending on the type of load and the cost of fuel at the time, it will likely cost you a few thousand to pay a trucking company to deliver the shipment.
You pay the transportation company up front, but you have a payment policy with Customer A where you give them a 30–60 day window to send a payment for the load. If the load costs $6,000, Customer A has an accounts receivable balance of $6,000. The impact from this transaction on your AR turnover ratio depends on when you can collect the $6,000 payment from Customer A, whether that is early, on-time, or late.
Purpose of AR Turnover Ratio
The accounts receivable turnover ratio is important because it offers insight into whether your company is struggling to collect on sales made via extending credit to customers. The ratio is a strong indicator of your company’s operational and financial performance and is a key metric in accounts receivable management.
How to Calculate Accounts Receivable Turnover Ratio
Net Credit Sales
Before figuring out your accounts receivable turnover ratio, you must first specify the time frame in which the formula is valid.
Are you trying to calculate your annual, quarterly, or monthly ratio? Once you have a time frame in mind, the ratio’s numerator will be the net credit sales.
Your AR turnover ratio might look like this: Quarterly credit sales / average accounts receivable.
Or, if you choose a monthly time frame: Monthly credit sales / average accounts receivable.
Average Accounts Receivable
The denominator of your ratio is the average balance of accounts receivable. If you’re doing this formula with a monthly time frame in mind, you would measure the average between where your company’s AR balance started at the end of the month and where it left off at the end of the month.
Understanding the Formula
Let’s say your company nets $20,000 in annual credit sales. At the beginning of the year, your accounts receivable balance is $5,000. At the end of the year, your balance is $3,000.
In this scenario, your accounts receivable turnover ratio formula for the year in question is 20,000 / ((5,000 + 3,000) / 2) = 5 times.
This means that all your open accounts receivable are collected and closed five times within a full year.
What is a Good Accounts Receivable Turnover Ratio?
A “good” accounts receivable turnover ratio varies by industry and company size. In general, a ratio that is higher than the industry average or that shows a consistent trend of improvement is considered a positive sign.
However, what is considered a “good” ratio can also depend on the specific circumstances and goals of a particular business. It’s important to monitor the AR turnover ratio over time to identify trends and make adjustments as needed to improve the company’s financial health.
High AR Turnover Ratios
High receivables turnover ratios may indicate:
- Your company’s accounts receivable collection method is efficient
- Your company has a significant portion of clients who pay their balances quickly
- Your company operates either completely or mostly on a cash basis
- Your company is very conservative about which customers it extends credit to
Put simply, a high receivables turnover ratio means your company uses its assets efficiently and is less likely to experience cash flow issues as a result.
Low AR Turnover Ratios
In general, a low AR turnover ratio isn’t a good thing. Low ratios usually indicate that:
- Your company has an inadequate process for collecting outstanding balances
- Your company has bad credit policies when it comes to issuing lines of credit and collecting on credit
- Your customers either aren’t financially viable or creditworthy
Here’s a more positive way to look at low turnover ratios: your company has an opportunity to reassess and evaluate its credit policies.
Safeguard Your Accounts Receivable Portfolio
The accounts receivable turnover ratio is a great metric to evaluate your performance, and leveraging resources like Moody’s Analytics Pulse can help you improve your ratio.
With Moody’s Analytics Pulse, you can constantly monitor the financial health of your customer portfolio. We’ll provide you with the real-time updates you need to make informed decisions and mitigate risk.
For more accounts receivable improvement ideas, explore our business credit blog. To discover the full range of capabilities Moody’s Analytics Pulse can offer your business, please reach out to us or schedule a demo today!