Businesses have assorted methods of receiving payment from their customers. Most accept a various mix of cash, checks, debit or credit cards. Some business customers use established lines of credit with negotiated terms, such as payment due dates or rates.
Payment methods that deal in credit are classified under accounts receivable. As you operate your business and track your financial information, you generate data on your accounts receivable. You'll have information such as the amount of time it takes each one of your customers to pay.
You can calculate the average number of days it takes to sell your goods or services on credit, and then collect payment. The result of this calculation is the Accounts Receivable Turnover Ratio.
Elements of the Calculation
You'll need to reference your business' balance sheet and income statement for the information. The accounts receivable turnover ratio is:
Net Annual Credit Sales ÷ ((Total Accounts Receivable) ÷ 2)
Net Annual Credit Sales is the total value of sales made for the year on credit, subtracting any returns, allowances, and discounts. Total accounts receivable is the sum of your beginning accounts receivable and your ending accounts receivable, divided by two.
Accounts Receivable Turnover Ratio Use
The result of the calculation is the number of times that your business' accounts receivable turned over in the past year. While you can keep the number as is, it is easier to understand if it is in days.
If you had an average accounts receivable turnover (the result of the equation) of 20, it means your average collection time is 18.25 days (365 ÷ 20). This means it takes 18 days on average to collect on your receivables.
High average collection times can be an indicator of collection policies in need of adjustment. However, this is not always the case. Your customers may not be receiving goods or services as promised, causing returns or refusals to pay.
A collection period with a high number of days is an indication that you may need to investigate something. Alternately, it could mean that the nature of your business results in slower collection times.
Low average accounts receivable collection times may be a signal that your collection policies are working. It might mean that your policies are too restrictive for buyers with less than impeccable credit. If this is the case, you could be losing customers to competitors with less restrictive collection policies.
You can also use your accounts receivable turnover ratio to compare your business with other companies in your industry. When comparing ratios, it is important to keep in mind that no two businesses operate exactly alike. Find businesses that are as similar to yours as possible for comparison.
Benefits of Using the Ratio
While the accounts receivable turnover ratio provides insight into the collection management of a company, it is best used as an informational tool. It doesn't always point to a problem with your collections staff or policies.
Use the ratio to identify any customer problems. Comparison of your accounts receivable can give you an indication of trends in collections. Identifying continuous late payments can keep a customer in financial trouble from using credit extended to them, by you, for purchases.
In addition to identifying customer payment trends, the most valuable use of the accounts receivable turnover ratio is having a tool to measure your own collection methods, address any issues, and find the most efficient collection period for your business.