How to Calculate Accounts Receivable Turnover Ratio
Getting paid is central to every business and front-of-mind for most business owners. The accounts receivable turnover ratio indicates how many times, on average, accounts receivables are collected during a year. The ratio evaluates the ability of a company to efficiently issue a credit to its customers and collect funds from them in a timely manner.
If the resulting ratio is high, there is a combination of a conservative credit policy and aggressive collections. Of course, a high-quality customer base is a prerequisite. If the ratio is low indicates a loose (or worse) credit policy and lackadaisical collections. It's also possible that the concern originates with the customer base, which itself may be experiencing a financial turndown. It is likely that with a low turnover ratio there is an excessive amount of bad debt.
Calculating the Accounts Receivable Turnover Ratio
The accounts receivable turnover ratio is calculated as follows: Net Annual Credit Sales/Accounts Receivable = # Times. Net annual credit sales are the total of all credit sales for a year, fewer returns, allowances, and discounts. Cash sales are not included. The net credit sales figure is taken from the firm's income statement and the accounts receivable figure is taken off the firm's balance sheet.
The result, number of times, is the number of times, each year, the firm's accounts receivables are collected or "cleaned up." To reiterate, if the result is high, it's generally a good thing. Customers are paying their bills on time. If the result is low, it may mean that the company's credit policies are too restrictive and its collection too lax.
Let's visit with Joe's Excellent Computer Repair and calculate their accounts receivable turnover rate for the past year, and let's use easy round numbers. At the beginning of the year, the accounts receivable credit balance was $100,000 and the ending balance was $200,000. Net credit sales for the year were $1,000,000. Per the formula, it's $1,000,000 divided by $300,000 / 2 or $1,000,000 divided by $150,000. This equals 6.7 accounts receivable turnover, which means that Joe's receivables turned over 6.7 times during the last year.
Therefore, the average accounts receivable was collected in 54.5 days. Not so hot. Joe needs to do some digging to find out why this is occurring, and what immediate action he should take.
- While the accounts receivable turnover ratio provides important insight into the financial management of a company by itself, it is most useful when compared to preceding time periods, perhaps the previous quarter and the previous year-to-date, to view any trends, whether up or down. Whether the trend is up or down, it is valuable to ascertain why and what action may be warranted.
- The beginning and ending accounts receivable balances represent an arbitrary point in time during a measurement year. The balances may vary considerably even a month later. Calculation of an accounts receivable turnover ratio with different dates may be advisable as you develop intelligence on any trends.
- The accounts receivable turnover ratio works with the average collection period ratio to determine the quality of a firm's receivables and the efficiency of the firm's collection and credit policies.