Accounts Receivable Turnover Ratio
The accounts receivable turnover ratio is also known as debtors’ turnover ratio, is a financial ratio that aids in measuring the company’s ability and effectiveness in collecting the money owed by clients. The ratio simply helps the business in identifying the speed at which it collects the money which it is to receive from its customers. If a company’s receivable turnover for a specific financial year is 20, this means that the company recovered the amount due from its customers 20 times during that specific financial year.
The formula used for debtors’ turnover ratio is as follows:
Debtors’ turnover ratio = Net annual credit sales ÷ Average accounts receivable
What Does the Receivables Turnover Ratio Mean?
As mentioned above, the receivable turnover ratio helps a company in measuring the efficiency with which it collects receivables or the credit it had offered to its clients/ customers. The ratio basically measures how many times the company was able to convert its receivables into cash in a specific period. The receivables/ debtors’ turnover ratio can be calculated on a monthly, quarterly, or annual basis.
An entity’s turnover ratio should be monitored on a consistent basis to identify whether a particular pattern or trend is developing over time.
For shareholders and other stakeholders, it’s important to compare accounts receivable turnover of different companies operating within the same industry to get an idea about what’s the average or normal turnover ratio for that particular sector. If a company has a higher turnover ratio when compared with that of another one then the company with the higher turnover ratio may prove to be a safer investment.
High Receivable Turnover
A high receivables turnover ratio indicates that an entity’s collection of receivable is efficient and that the entity has more quality customers that like to pay their debts as quickly as possible. A high receivables turnover ratio may also indicate that the entity is operating on a cash basis rather than an accrual basis.
A high ratio could also suggest that the entity is conservative in extending credit to its clients/ customers. Conservative credit policy could prove beneficial for many businesses as it helps business entities in avoiding extending credit to clients/ customers that may not be able to clear their dues on time.
On the flip side, if an entity’s credit policy is way too conservative then it might drive away potential clients to competitors who may extend them credit. If a business is suffering due to slow growth or losing clients then it would be wiser to just loosen your credit policy to improve revenue, even though it might lead to a lower receivable turnover ratio.
Low Receivable Turnover
A low receivables turnover ratio may indicate towards the company having bad credit policies, ineffective and inefficient collection processes, or clients that are not financially creditworthy or viable.
Typically, a low turnover ratio implies that the business should reassess its policies regarding extending credit to customers, to ensure collection of its receivables on a timely basis.
Example of Receivables Turnover Ratio
Company ABC had the following results for the year:
- Net Sales made on credit = $3,000,000
- Accounts receivable at the start of the year = 150,000
- Accounts receivable at the end of the year = 200,000
We can calculate the receivables turnover ratio by using the above-mentioned data as follows:
- Average Receivables = (150,000 + 200,000)/ 2 = $175,000
- Accounts Receivable Turnover = $3,000,000/ $175,000 = 17.14
We can interpret the above-calculated turnover ratio to mean that Company ABC collected its receivables 17.14 times on average that year. In other words, the entity converted its accounts receivable to cash 17.14 times that year. A company could compare turnover ratios of multiple years to determine whether 17.14 is an improvement or an indication of a slower accounts receivable collection process.
ABC Company could also calculate the average time duration of receivables or the number of days it took the company to collect its receivables during the year. The average receivables turnover in days for the above example is as follows:
Average receivables turnover in days = 365/ 11.76 = 21.29 days.
Customers of Company ABC, take 21.29 days on average to pay their outstanding balances. If the company offers its customers a credit period of 20 days then its average receivables turnover shows that on average its customers are clearing their dues one day late.
A company can improve its turnover ratio by making changes to its collection process. A company could also use the tactic of offering discounts to its customers to lure them in paying early. It’s important for business entities to have knowledge about their receivables turnover since it is directly related to how much cash will be available to them for paying their short term liabilities.