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Accounts receivable turnover ratio, also known as debtor turnover ratio, is an accounting measure used to calculate how efficient a company is in managing credit and collecting receivables from its clients. This metric is used to show how many times a company’s accounts receivables (unpaid invoices) are collected and converted into cash during a specified period, usually for the financial year.
Generally, the higher the measure of accounts receivable (A/R) turnover ratio, the more efficient a business is at collecting payments. A higher ratio indicates that customers pay on time or earlier and this typically results in positive cash flow and enhanced working capital management for the business. A low A/R turnover ratio could signal that collection processes are inefficient, credit policies are too lax, the business’ clients are not creditworthy or customer concentration is particularly high.
A basic formula for calculating the accounts receivable turnover ratio is:
Net Credit Sales / Average Accounts Receivable = Accounts Receivable Turnover Ratio
Net Credit Sales is total credit credit sales during a specific period (usually a year) minus any returns and allowances;
Average Accounts Receivable is the average of the beginning and ending accounts receivable balances during the same period.
Using this formula, here’s an example calculation for Company XYZ…
Let’s say Company XYZ wants to calculate its accounts receivable turnover ratio for the fiscal year 2022.
So, in this example, Company XYZ’s accounts receivable turnover ratio for the year 2022 is approximately 7.09. This means that on average, the company collected its accounts receivable 7.09 times during the year. A higher turnover ratio generally means better efficiency in collecting payments from customers. However, the interpretation of this ratio can vary based on the company’s specific circumstances and industry norms.
As a very rough guideline an A/R turnover ratio of 5-10 may be considered reasonable for most industries, however, this really varies depending on the average for your particular industry, your business model and specific situation.
If your industry peers are averaging 10 and you’re at 7, there may be something amiss. Also, if your credit terms are 30 days net and you’re only averaging 4 for A/R turnover ratio for example, you’d be expecting to be closer to 12 if your clients were regularly paying on time.
So, generally, the higher the turnover ratio the better but businesses with longer credit terms will naturally have a lower score and businesses with shorter terms will tend to have a higher score. Some companies will also make a strategic decision to operate on the lower side of A/R turnover ratio in order to maintain key customer relationships.
It’s good practice to monitor trends in A/R turnover over time to gain an accurate picture of the business’ financial health and performance. Maintaining a healthy accounts receivable turnover ratio is beneficial to businesses for several reasons, the primary benefits being;
Striking the right balance between efficient collections and maintaining good customer relationships is crucial. An excessively high turnover ratio might suggest overly strict credit policies that can discourage new business. Furthermore, the appropriate level of accounts receivable turnover can vary by industry, so it’s important to consider industry benchmarks and the company’s specific circumstances when interpreting the ratio.
Not all businesses will be in the enviable position of having a high A/R turnover ratio, not through any mis-management on their part but because their business model is just inherently inclined to be on the low side. Industries such as temporary staffing and manufacturing typically have longer credit cycles which makes a lower A/R ratio normal for companies in these sectors; the downside of this however is that traditional finance options will likely be limited for these businesses putting them in a difficult situation when it comes to cash flow.
So, accounts receivable turnover ratio is an important indicator of the financial health of a company but it should be carefully interpreted and used in combination with other metrics when determining a business’ eligibility for finance. Whilst a low A/R turnover could preclude some businesses from obtaining conventional finance, alternative finance such as invoice factoring can help businesses by releasing the value of their unpaid invoices and providing the influx of working capital they need to improve their accounts receivable position.
Reach out to the Sallyport team for more information on working capital solutions for short-term financing needs that fill a gap without adding debt.
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