How to Calculate Accounts Receivable Turnover

Accounts Receivable (AR) Turnover is a financial metric that helps businesses evaluate how efficiently they collect payments from customers who have purchased goods or services on credit. Monitoring this ratio provides insights into a company’s cash flow management and helps inform decisions about credit policies and collection efforts.

What is Accounts Receivable Turnover?

Accounts Receivable Turnover measures how many times a company collects its average accounts receivable balance over a specific period, typically a year. It shows how quickly a business converts credit sales into cash. A higher turnover indicates efficient payment collection and effective credit policies.

Businesses track this ratio to assess their liquidity and the effectiveness of their credit terms and collection processes. Efficient collection supports steady cash flow, which is crucial for operational expenses and growth. Conversely, slow collections tie up capital, hindering a company’s ability to meet financial obligations or invest in new opportunities.

Identifying the Data for Calculation

To calculate the Accounts Receivable Turnover ratio, two components are required: Net Credit Sales and Average Accounts Receivable. These figures are found on a company’s financial statements.

Net Credit Sales represent total revenue from sales made on credit, after accounting for any sales returns, allowances, or discounts. Cash sales must be excluded, as they do not generate accounts receivable. This value reflects the actual credit sales amount that a company expects to convert into cash.

Average Accounts Receivable is the average amount owed to a business by its customers over a specific period. This average is calculated by adding the accounts receivable balance at the beginning of the period to the balance at the end, then dividing the sum by two. For example, if a company’s accounts receivable was $50,000 at the start of the year and $70,000 at the end, the average would be ($50,000 + $70,000) / 2 = $60,000. Accounts receivable balances are found on the balance sheet, listed under current assets because they represent amounts expected to be converted into cash within one year.

Steps to Calculate Accounts Receivable Turnover

The formula for this calculation is: Accounts Receivable Turnover = Net Credit Sales / Average Accounts Receivable. Both numbers should represent the same accounting period to ensure an accurate calculation.

For example, consider a business that recorded $500,000 in net credit sales over the past year. At the beginning of that year, its accounts receivable balance was $40,000, and at the end of the year, it was $60,000. First, calculate the Average Accounts Receivable: ($40,000 + $60,000) / 2 = $50,000. Then, apply the formula: $500,000 (Net Credit Sales) / $50,000 (Average Accounts Receivable) = 10.0. This indicates the company collected its average accounts receivable 10 times during the year.

Understanding Your Accounts Receivable Turnover Ratio

Interpreting the Accounts Receivable Turnover ratio provides insights into a company’s financial and operational performance. A high ratio suggests efficient collection of receivables, indicating effective credit management and healthy cash flow. This often means customers settle invoices promptly, reducing bad debt risk and improving liquidity. A higher ratio can also imply a conservative credit policy or a customer base with strong financial health.

Conversely, a low ratio may signal issues with collections, inefficient credit policies, or customers taking longer to pay. This can lead to cash flow problems as funds are tied up in outstanding receivables, impacting a business’s ability to cover expenses or pursue growth. Factors influencing this ratio include credit terms, collection efforts, economic conditions, and customer creditworthiness. The ideal ratio varies by industry, making it important to compare a company’s ratio against industry benchmarks for a meaningful assessment.

Calculating Days Sales Outstanding (DSO)

Days Sales Outstanding (DSO) is a complementary metric that provides further insight into a company’s collection efficiency by measuring the average number of days it takes to collect accounts receivable. This metric is derived from the Accounts Receivable Turnover ratio and offers a time-based perspective on how quickly credit sales convert into cash.

The formula for calculating DSO is: DSO = 365 Days / Accounts Receivable Turnover Ratio. For example, using the previous calculation where the Accounts Receivable Turnover ratio was 10.0, the DSO would be 365 days / 10.0 = 36.5 days. This means, on average, it takes the company approximately 36.5 days to collect payment after a sale. A lower DSO value is more favorable, as it indicates quicker collection of receivables and faster conversion of credit sales into cash. A higher DSO suggests delays in payment collection, which strains a company’s cash flow. Analyzing DSO alongside the Accounts Receivable Turnover ratio offers a more comprehensive view of a company’s credit and collection performance.