What Is Accounts Receivable Turnover?
Explore accounts receivable turnover to gauge a company's efficiency in collecting credit sales and its overall financial liquidity.
Accounts receivable turnover is a financial metric that provides insight into how efficiently a company collects its credit sales. It measures how many times a business converts outstanding customer credit into cash within an accounting period. This ratio assesses a company’s liquidity—its ability to meet short-term obligations—and its operational efficiency in managing customer credit. Effective management of accounts receivable helps maintain healthy cash flow for operations and growth.
How to Calculate Accounts Receivable Turnover
The accounts receivable turnover ratio involves two primary components: net credit sales and average accounts receivable. The formula is Net Credit Sales divided by Average Accounts Receivable.
Net credit sales refers to revenue generated from sales made on credit, after accounting for any reductions. Total credit sales are reduced by sales returns, which occur when customers send back products, and sales allowances, which are price reductions for issues like damaged goods or billing errors.
Average accounts receivable is calculated by adding the accounts receivable balance at the beginning of a period to the balance at the end, then dividing by two. Using an average helps smooth out fluctuations, providing a more representative figure. For example, if beginning receivables were $70,000 and ending were $85,000, the average is $77,500. With net credit sales of $1,000,000, the ratio is $1,000,000 / $77,500, or approximately 12.9 times.
What the Turnover Ratio Indicates
The accounts receivable turnover ratio indicates a company’s financial and operational performance. A high ratio suggests efficiency in collecting receivables, indicating effective credit policies and strong cash flow. Prompt customer payments provide the business with more readily available cash for operations and investments.
Conversely, a low accounts receivable turnover ratio signals issues in collection processes. It may indicate inefficient collection efforts, overly lenient credit policies, or customers experiencing financial difficulties hindering timely payment. A low ratio ties up capital in outstanding receivables, potentially leading to cash flow shortages and increased financial risk.
Comparing the ratio against a company’s historical performance provides insight into trends and changes in collection efficiency over time. Comparing it to industry averages or competitors’ ratios is important because what constitutes a “good” or “bad” ratio varies significantly across different industries.
Retail and grocery stores, for instance, exhibit higher turnover due to cash-heavy operations and immediate payment expectations. Conversely, B2B sectors may have lower ratios due to longer payment terms, such as 30 or 60 days.
The accounts receivable turnover ratio is closely related to “Days Sales Outstanding” (DSO), representing the average days to collect receivables. DSO is calculated by dividing 365 days by the accounts receivable turnover ratio. A higher turnover ratio directly translates to a lower DSO, meaning credit sales convert to cash more quickly. For instance, a turnover ratio of 12.9 times results in a DSO of approximately 28 days (365 / 12.9).
Business Practices and External Factors Affecting the Ratio
A company’s internal business practices influence its accounts receivable turnover ratio. Credit policies, defining terms for extending credit, directly impact collection speed.
More stringent terms (e.g., shorter payment due dates or lower credit limits) lead to a higher turnover by encouraging faster payments. Conversely, lenient terms (e.g., extended payment periods) can result in a lower ratio as customers have more time to pay.
The effectiveness of a company’s collection efforts plays a role. This includes procedures for following up on overdue accounts, the frequency of reminders, and the application of incentives for early payments or penalties for late payments. An organized and proactive collection department can improve the turnover ratio by reducing the time outstanding invoices remain uncollected.
Changes in sales volume and the mix of sales can affect the ratio. An increase in credit sales relative to cash sales, for example, will increase the amount of accounts receivable, potentially impacting the turnover ratio if collection efficiency does not keep pace.
The financial health and payment habits of a company’s customer base are important. Businesses with a customer base that is financially stable and consistently pays on time will exhibit a higher accounts receivable turnover.
Beyond internal practices, external factors can exert influence on the accounts receivable turnover ratio. Economic conditions, such as a recession or an economic downturn, can impact customers’ ability to make timely payments. During periods of economic contraction, customers may experience financial strain, leading to slower payments and a lower accounts receivable turnover for businesses.
Industry norms establish inherent payment cycles and credit terms that affect turnover ratios. For instance, some industries traditionally offer longer payment terms due to the nature of their products or services, which can result in a lower average turnover across the sector.
The competitive landscape can pressure companies to offer more lenient credit terms to attract or retain customers. If competitors are providing extended payment periods, a business might feel compelled to match these terms, potentially leading to a lower turnover ratio to remain competitive.