The account receivables turnover ratio is a metric employed to determine how effective a company is to collect the money owed by its clients. The timely collection of receivables is crucial to maintain a healthy cash flow. If a company is unable to collect the money it is owed, it will quickly face financial challenges and it could result, in the most severe cases, in the main reason for a bankruptcy.
What is AR Turnover?
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Businesses employ the account receivables turnover ratio to analyze the performance of their billing department, and also the quality of their client’s portfolio. On the other hand, companies are more susceptible to others when it comes to receivables. This is the case for wholesalers and manufacturing businesses that sell large volumes and usually have a substantial amount of money yet to be collected.
Also, small to mid-sized businesses whose sales are highly concentrated within a handful of big clients can suffer severely from a delay in payment from any of them. This makes the account receivables turnover ratio an important metric to follow up on.
Accounts Receivable Turnover Formula
Here’s how the account’s receivable turnover ratio formula can be calculated:
Accounts Receivable Turnover Ratio = Net Credit Sales / Avg. Accounts Receivable
AR Turnover Ratio Equation Components
Net Credit Sales: The aggregate revenues received and paid for through commercial credit.
Avg. Accounts Receivables: The average between the total accounts receivable outstanding in the beginning of the time period being evaluated and the end period.
The result of this formula is expressed as the number of times net credit sales have been collected during that time period. For example, a ratio of 5 means that the accounts receivable have been collected 5 times during that time period. It also means, using the above-mentioned example, that the company has 20% of its sales tied up on receivables.
Receivables Turnover Ratio Equation in Days
On the other hand, in order to express the turnover ratio in days, which facilitates the interpretation of the ratio, the following formula can be employed:
Accounts Receivable Turnover Ratio (in days) = 365 / (Net Credit Sales / Avg. Accounts Receivable)
Using the latest example, a company with an accounts receivable turnover ratio of 5 collects all of its receivables in 73 days, on average.
Accounts Receivable Turnover Example
Silver Cook is a company that manufactures and sells aluminum foil for households and businesses. The company has a small product line, that consists in 3 different products of different qualities, and each product has a different size, depending on the length of the foil.
The company recently evaluated its cash flow situation and the Financial Department warned the Board of Directors that in the next 6 months the company would incur in a cash deficit. As a result, the CEO decided to investigate the reason for this and its initial step was to calculate the accounts receivable turnover ratio. The company’s year-to-date sales were $12,450,000 and accounts receivable at the beginning of the year were $1,850,000 and currently, $2,204,000. As a result, the calculation of the ratio will look like this:
Accounts Receivable Turnover Ratio = $12,450,000 / ((1,850,000 + $2,204,000)/2) = 6.14
This means that the company’s accounts receivable have been fully collected 6 times this year. Currently, 165 days have passed since the year started, therefore the average number of days it takes the firm to collect receivables is:
Accounts Receivable Turnover Ratio (in days) = 165 / 6.14 = 27 days.
This metric appears to be healthy, compared to perhaps other businesses. Nevertheless, Silver Cook has been implementing a strict policy on credit sales and the longest credit period they have been extending to clients is 15 days. It appears the collection process has not been successful and that could be one of the reasons why the company is struggling with its cash flow.
A/R Turnover Ratio Analysis
The accounts receivable turnover ratio has the capacity to signal potential billing and collection issues going on within the business. It can be employed as an indicator of whether a further audit needs to be carried out on the receivables department, in order to understand why the metric is behaving as it is.
A significantly low account receivables turnover ratio may indicate that the collection process is not effective and clients are taking more than they should to pay for their invoices. On the other hand, a significantly high ratio it’s usually an indication that the collection process is working efficiently.
The most common way to analyze if the ratio is healthy or not is to compare the result (in days) with the average credit period extended to clients. If the ratio exceeds that period substantially, then the collection process is definitely experiencing issues. On the other hand, if the ratio is lower than that, it may mean that clients are taking advantage of an existing discount on early payments or it could also mean that the inventory turnover is quicker than the credit period and, usually, clients have to pay for outstanding invoices before they are allowed to make a new order.
As seen in the example above, Silver Cook had a ratio of 27 days, which a first glance may not sound alarming. Nevertheless, when compared to the average credit period, the ratio unveils what could be the main cause for the cash flow problem the company is experiencing. In this case, the proper solution would be to push clients to comply with the credit period by imposing penalties on late payments or even through legal enforcement.
Receivables Turnover Uses, Cautions, and Pitfalls
There are a few potential situations where the accounts receivable turnover ratio may turn out to be a misleading indicator. For example, a company with declining revenues may obtain a low turnover ratio that doesn’t really indicate an issue with receivables per se, since the accounts receivable from higher sales coming from previous periods are distorting the metric.
On the other hand, a company that’s experiencing a recent growth in its sales may see a significantly low turnover ratio coming from the fact that the new increase in sales is only a small portion of the entire portfolio of receivables.
In this sense, comparing the evolution of the accounts receivable turnover ratio over different periods of time may help to avoid these issues, as an analyst can quickly identify drastic changes in the ratio that may not be backed by actual changes in the collection efficiency.
Finally, comparing the accounts receivable turnover ratio with other metrics such as the inventory turnover ratio and the days of sales outstanding may be helpful to understand the “big picture” of how the company cash cycle is functioning at any given moment in time.