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Last Updated on May 16, 2022

There are many calculations and metrics that can provide valuable insight into your business operations and financials. One metric, the Accounts Receivable Turnover ratio, it’s useful to track how efficiently you collect debts from customers to whom you have extended credit. Too many late or delinquent payments negatively impact cash flow.

Here’s what business owners need to know about calculating the Accounts Receivable Turnover ratio to better monitor the health of their business.

What Is the Accounts Receivable Turnover Ratio?

Many companies extend credit to customers. The Accounts Receivable Turnover ratio measures how efficiently a company collects from credit customers. It essentially measures how many times a company collects its outstanding receivables over a specified period.

What Are the Benefits of Calculating the Accounts Receivable Turnover Ratio?

The Accounts Receivable Turnover ratio can tell you two key things about your business. First, it indicates how many days it takes to collect credit payments so you can better make financial decisions regarding cash flow. Secondly, the ratio can help determine if your policies and terms related to credit need to be tightened or perhaps even loosened.

Although what constitutes a good ratio varies for different industries, a  higher ratio typically indicates a faster collection period and healthier cash flow. A business that collects receivables on time tends to be more financially stable.

How Does the Accounts Receivable Turnover Ratio Compare to Asset Turnover Ratio?

An Asset Turnover ratio measures if a company is using its assets in an efficient way, generating a high number of sales. In contrast, the Accounts Receivable Turnover ratio measures how well a company collects outstanding receivables, or money owed from customers.

If a business revenue is higher than the value of its assets, the business is profitable. An inability to collect accounts receivables means the company won’t have the necessary assets to generate revenue.

These ratios measure the efficiency of a business and allow businesses owners and investors to conclude if a company is profitable or not.

A low Accounts Receivable Turnover ratio shows that a company needs to improve its ability of collecting receivables. A low Asset Turnover ratio is a sign that the assets are not being used efficiently to generate profits.

How Do You Calculate Accounts Receivable Turnover Ratio

The calculation of the Accounts Receivable Turnover ratio is a three-step process. You first need to determine your net credit sales that will be used in the equation. Then you calculate the average accounts receivable. Finally, you calculate accounts receivable turnover. Here is a breakdown of each step:

Finding net credit sales

You get your net credit sales number from your balance sheet or annual profit & loss statement. You need two pieces of information: Total Credit Sales for the year and Total Credit Returns for the year. Subtracting Total Credit Returns from Total Credit Sales will give you Net Credit Sales. So this first step is:

Net Credit Sales = Total Credit Sales – Total Credit Returns

Finding the Average Accounts Receivable

You’ll find your accounts receivable numbers on your company balance sheet. You need your accounts receivable value for the start of the year and your accounts receivable value for the end of the year. Add these together and then divide the total by two. This second step looks like this:

Average Accounts Receivable = (Beginning AR + Ending AR) ÷ 2

Finding the Accounts Receivable Turnover Ratio

Use the numbers from the above two steps to get the ratio. You divide the Net Credit Sales by the Average Accounts Receivable to calculate the Accounts Receivable Turnover ratio. So this last step is:

Accounts Receivable Turnover Ratio  = Net Credit Sales for the year + Average Accounts Receivable

Here is the entire equation:

Net Credit Sales = Total Credit Sales – Total Credit Returns

Average Accounts Receivable = (Beginning AR + Ending AR) ÷ 2

Accounts Receivable Turnover Ratio  = Net Credit Sales for the year + Average Accounts Receivable

What Are the Key Takeaways for Businesses?

Once you determine your Accounts Receivable Turnover ratio, you can use it to evaluate your business.

A low ratio can signal that you need to tighten credit terms. However, some industries require longer terms to meet customer needs. Tighten terms too much, and your ratio could swing too far the other way.

A higher ratio may indicate that you need to loosen your credit terms. You could be losing business to competitors with more lenient payment terms. To improve our ratio, look at changing your credit policy or making sure your customers are better aware of your policy to encourage timely payment.

The Accounts Receivable Turnover ratio can be used to compare your business to others. Just be sure to compare to others in your industry, even if they aren’t direct competitors. Comparing your ratio to that of companies outside of your industry will not provide any sort of accurate comparison.

What Are the Potential Limitations of Relying on Accounts Receivable Turnover Ratio?

The usefulness of the Accounts Receivable Turnover ratio depends on a few things. It does not mean much on its own. You need to compare current and past ratios and compare it to your competitors.

First, this metric does not apply the same to every industry. A cash-heavy business may have a very high Accounts Receivable Turnover ratio. A high ratio likely doesn’t matter for a cash-heavy business since little credit is extended.

Secondly, keep in mind that while a low ratio may indicate a problem collecting receivables, it won’t tell you why. You’ll need to look further into business policies and practices and maybe even your customers to determine any problems.

If you have a cyclical business, this ratio does not always provide an accurate picture. To determine accuracy, you may need to use other metrics or reports.

Bottom Line

When used as a comparative metric, the Accounts Receivable Turnover ratio can indicate how well your company is at extending credit and collecting its accounts receivables. Too many outstanding receivables can cause a cash flow problem, preventing you from meeting the company’s financial obligations or growing the business.

Just make sure you use this metric in context to avoid making business decisions with inaccurate data. A very low ratio, compared to previous years’ ratios or competitors, or a very high ratio can indicate your need to change your credit policies.