Last Updated on August 26, 2021
If your company operates in the retail industry or provides a product or service, you’ll need to know how effective your collections efforts are during the year. There is a method for determining this information: your accounts receivable turnover ratio.
It may sound complicated, but calculating this ratio is pretty simple. This is something every business owner should be able to find and evaluate — especially if you want your small business to continue to grow.
The following information helps you find the figures you need to get an accounts receivable ratio and gives you feedback about that figure and whether it’s a good ratio for your particular operation.
What is Accounts Receivable Turnover Ratio?
If you want to determine how well your company is collecting debt from customers using collections methods and credit card payments, you need to determine the accounts receivable turnover ratio. This figure is a good barometer for the effectiveness of the collections and payments on account and debts determined through the year.
The formula for calculating the accounts receivable turnover ratio is pretty simple. You take the net credit sales and divide it by your average accounts receivable figure.
An example of calculating this figure would be like this:
You have $1000 in total credit card sales and accounts receivable figure of $25. You would divide the $1000 by $25 to get a figure of 4. You can perform this calculation with any figure. The idea is to get a higher number, which indicates more efficient collection processes set internally.
Example: $1000 credit debt/divided by/$25 accounts receivable figure= 4
How to Determine Your Net Credit Sales
If you want to figure out the number for your net credit sales, you’ll want to know the sales information from the year. You need all the credit sale information from the year to arrive at accurate figures.
This likely means you need access to all sales reports for the month for accuracy. If you have accounting software or an accountant in your company, they can provide the information quickly and efficiently. Keep in mind that this information is inclusive of both online sales and in-store sales.
How to Figure Your Average Accounts Receivable Number
You’ll need to have average accounts receivable figures to perform the calculation correctly. This process requires another calculation: find your accounts receivable figures from the beginning of the year and add them with the figure from the end of the year.
Since you have two figures, you’ll divide the number by two to find the average.
Example: $10,000 + $15,000= $25,000
Divide $25,000 by 2 to get $12,500 as the average. This is the second figure to calculate the accounts receivable turnover ratio.
Figuring Your Accounts Receivable Average
If you’ve successfully found your net credit sales figure for the year, you’ll need to find the accounts receivable average next.
Because it’s an average, that means you need at least two figures, which will be divided to get another figure. The final figure is what you use for the accounts receivable calculation. To accomplish this, you’ll need to follow the steps mentioned in the previous example. As long as you follow every step carefully, it shouldn’t be too hard!
To reiterate, the formula is the beginning of the year and end of the year accounts receivable figures added together and divided by two.
The result of dividing your total, or net, credit sales and the accounts receivable average is the accounts receivable turnover ratio.
It’s important to note that accounts receivable only refers to credit sales and not actual cash sales. The ratio number reflects the number of payments made by credit customers; that’s why having a higher number is better than a lower number.
You want more payments to reflect the customer paying your company back for credit extended.
What’s a Good Ratio?
When it comes to an accounts receivable turnover ratio, a higher number is better because it tells you that your collection efforts are up to speed for your industry.
To dig further into the detail, it means your customers pay their debts frequently and increase their lines of credit. Ways to keep that number high include the following.
- Carefully extending credit
- Tailoring collection strategies
- Working with regular customers
- Adjusting credit policies as needed
Carefully focusing on your credit extensions and customer accounts is the best way to keep your AR ratio higher.
What it Means When your Accounts Receivable Turnover Ratio is Too High
If you have a high accounts receivable turnover ratio, it can mean a few different things. It can mean your company is providing credit to ideal customers. It can also indicate your collections department has a solid approach that works.
However, keep in mind that a high AR ratio may not accurately reflect how your company handles credit if the majority of your business is done with cash, so that’s something to consider and make adjustments for when calculating the figures yearly. Read our full article on COD businesses, or cash on delivery.
You can have a figure that’s actually too high! It could mean your strategy for collecting on credit accounts is too aggressive. It can also mean you may miss out on more sales from some customers with average credit rather than targeting those with good to excellent credit.
There’s a possibility of missed chances to increase sales and create new relationships with potential customers that may end up being long-term clients. It’s a fine balancing act, and that’s why getting these calculations regularly and analyzing policies and actions related to those figures can help a company maintain or increase sales and expand credit options.
What it Means When an Accounts Receivable Turnover Ratio is Too Low
If your accounts receivable ratio is low, it can reflect some things that need changing within the business concerning credit policies. For instance, it can mean that you have a high amount of bad debt or uncollected receivables.
It may also mean you don’t have a strict enough credit policy or need to adjust your credit collection tactics to be more effective.
Something to consider is that some may have issues paying back their credit and may need to work with you to pay it back. They may remain a customer if efforts are made to extend courtesy in this event.
The credit policies and collections methods may not be the only issue with a company that has a low AR ratio. This number may reflect customer service or care and other business processes related to sales and customer satisfaction.
Tips for Tracking your Accounts Receivable Turnover Ratio
If you want to stabilize or maintain your accounts receivable ratio, you can try the following approaches.
First, you want to make your credit and payment policies very clear to the customer. Let them know what’s expected and how you collect in advance. Provide the customer with statements to help them stay on track and make sure you use accounting software for accuracy.
Most companies offer multiple payment methods because they know it helps them collect on accounts more effectively. Consider taking PayPal, various credit cards, debit cards, and Venmo, for example. Customers are more likely to pay on time when they have options that make it convenient.
Don’t forget to send reminders for upcoming payments, so the customer doesn’t forget. People can forget, and it can hurt both them and your company.
Limitations of Accounts Receivable Turnover Ratio
While knowing your AR ratio is extremely helpful for streamlining business and credit processes, it does have certain limitations, including the following.
- Errors in figures when using your total sales. You should use net sales to keep your number on track rather than inflating it.
- Business flow related to times of the year. If you notice, there’s usually an ebb and flow of business related to the year. You may want to consider this factor when choosing the times to do your calculations.
- Competition in the industry. If you want to get an accurate assessment of how your company is doing in its market, be sure to use the right competitors. If you try to gauge your progress with the wrong companies, you’ll do a disservice to your efforts.
Although these figures can help alert to issues, they can have various factors to consider, and finding the cause can take some research and footwork.
Every growing business has an accounts receivable turnover ratio. Knowing this ratio is the best way to track your growth and give your small business the tools it needs to succeed.
Now that you know how to calculate and evaluate your ratio, you can help your company reach new heights.
Grey is the Director of Marketing for altLINE by The Southern Bank. With 10 years’ experience in digital marketing, content creation and small business operations, he helps businesses find the information they need to make informed decisions about invoice factoring and A/R financing.