What is Accounts Receivable Turnover Ratio?

The Accounts Receivable Turnover Ratio is a simple accounting tool to measure how efficient a company is at extending credit to customers and recovering these debts on time.

A high accounts receivable turnover ratio indicates that credit management processes are working well and that customers are settling their debts on time. A low ratio indicates that credit may have been extended to unreliable or uncreditworthy customers, or that in-house debt collection procedures are inefficient.

The accounts receivable turnover ratio is commonly used to gauge efficiency, optimise internal processes, and maximise profitability.

When a business transaction takes place and the buyer receives goods or services on the agreement that they pay for them later, the money that is due to the seller is referred to as “Accounts Receivable.” A company may allow its clients to pay upon delivery or extend a line of credit repayable later, typically 30, 60 or 90 days after the date of invoice. Finding the right balance between extending attractive credit options to clients and ensuring invoices are paid is key to good financial health. 

A high accounts receivable turnover ratio indicates that a company is highly efficient at assessing risk before extending a credit or at recovering debt from its clients, i.e. ensuring that clients pay their debts in a timely way and minimising bad debts – or both. A less efficient company will have a lower accounts receivable turnover ratio, which may indicate that either its processes are inefficient, or that its clients are uncreditworthy.

The accounts receivable turnover ratio is a measurement of efficiency. It measures how many times a company’s receivables (credits) are paid (converted into cash) over a specific period of time. The accounts receivable turnover ratio is calculated on a monthly, quarterly, or annual basis. 

The formula for calculating the accounts receivable turnover involves dividing a company’s net credit sales by its average account receivables. 

The term “net credit sales” refers to the amount of revenue the company has generated over the specific period of time (usually a month, quarter, or year) and paid by credit. This includes all sales on credit, minus sales returns, and sales discounts.

The term “average accounts receivable” refers to the average between a company’s accounts receivable balance at the start of the relevant period and its accounts receivable balance at the end of the period, divided by two. 

A typical example would be a store which sells furniture to major hotel chains. Over the course of a quarter, the store made €350,000 in gross sales. The accounts receivable at the start of the quarter were €40,000 and at the end of the quarter were €70,000. The accounts receivable turnover ratio for this quarter would be:

Accounts Receivable Turnover Ratio = €350,000 – €40,000 / (€40,000 + €70,000 / 2) = 5.6 

The accounts receivable turnover ratio in this case is 5.6.

This figure can then be used to calculate the average number of days it takes customers to settle their credit invoices, by dividing the number of days in the specific period (here a quarter, 91 days) by the accounts receivable turnover ratio.

Accounts Receivable Turnover in Days = 91 / 5.6 = 16.25 days.

This figure indicates that, when the credit period is 91 days, customers on average settle their invoices within 16.25 days.  

As a rule, companies should be aiming for a higher accounts receivable turnover ratio, but as with everything in corporate finance, the devil is in the detail.

Although a high accounts receivable turnover ratio is usually a good sign, an overly high ratio can indicate that the company is reluctant to extend credit or is overly zealous in collecting debts. Either of these can have a negative impact on how attractive the company appears to potential clients. When market competitors offer more flexible payment schedules or reasonable timescales, clients can be easily swayed, resulting in lost sales.

Finding the perfect balance is the key to success.

Analysing a company's accounts receivable turnover ratio is important to identify weaknesses and determine when to make changes. However, this metric is not particularly useful on its own. It becomes more valuable when compared to industry benchmarks.) 

The most appropriate comparisons are to be made with companies of a similar size operating in the same industry. The more similarities between the two companies being compared, the more accurate and revealing the comparison will be. It is unlikely to be useful to compare the accounts receivable turnover ratio of an SME providing local restaurants and hotels with hand-made bread to a major industrial supplier mass producing bread for the catering industry. A more useful comparison would be with a similar sized SME providing a similar product to restaurants in a neighbouring city. 

Several factors can influence the accounts receivable turnover ratio, including the nature of the industry, the customer base, the credit terms that are used, payment policies, seasonal fluctuations, and economic conditions. 

For example, a manufacturer selling ski equipment to retail stores may see credit sales double in the run-up to the winter ski season. Its accounts receivable turnover ratio in the quarter leading up to the start of the ski season may therefore be much higher than the same ratio during the spring or summer months. Monitoring the annual ratio over the entire year is, therefore, more likely to render useful information than slavishly tracking monthly or quarterly differences.

We have seen how the accounts receivable turnover ratio can be used to identify strengths and weaknesses in a company’s credit and debt management procedures. Changes in the ratio can help identify the right time to loosen up the credit policy to boost sales or to draw back customers from more flexible competitors. Should the ratio drop too low, it may be time to tighten up credit procedures and be more aggressive about debt collection efforts.

Finding the perfect balance is key to strategic financial planning, identifying opportunities to improve procedures and forecast future cash flows. A healthy accounts receivable turnover ratio is also a good indicator for potential investors of the general state of the company.

Knowing how to calculate and track your company’s accounts receivable turnover ratio is essential to ensuring your company offers attractive credit options to potential clients and maintains a healthy cash flow and minimises bad debts.

Regularly benchmarking your company’s turnover ratio against similar companies in the same industry can help identify areas for improvement and can pinpoint the right time to make key business changes.

Find out how Allianz Trade can help you calculate and analyse your accounts receivable turnover ratio to optimise your procedures and contribute towards evidence-based financial planning.