What are accounts receivable?
Accounts receivable (AR) is an accounting term that describes the total balance due from customers for goods or services purchased. AR is also defined as sales made on credit.
Cash sales do not impact a company’s accounts receivable. If a large percentage of your customer base operates on a cash basis, customer payments are made at the time of sale, and you can spend less time on collection efforts.
Since a company’s receivables are expected to be paid in 12 months or less, they are categorized as current assets in the financial statements, including the balance sheet.
What are some accounts receivable examples?
Unpaid customer invoices make up the accounts receivable balance. Any portion of an invoice that is unpaid is posted to accounts receivable. If a customer pays by credit card and the credit card payment has yet to be posted, the balance is added to accounts receivable.
What is the accounts receivable turnover ratio?
The accounts receivable (AR) turnover ratio measures how quickly a business collects cash from credit sales.
The ratio measures how often a company collects its average accounts receivable balance in cash during an accounting period. The period of time may be a month, quarter, or year.
Further learning: This article provides several best practices for effective cash management.
An efficiency ratio (including an asset turnover ratio) measures how quickly a particular asset (accounts receivable, inventory, etc.) can be converted into cash. CFOs strive to speed up cash collections.
Accounts receivable turnover ratio formula
The accounts receivable turnover ratio is (net credit sales) / (average accounts receivable).
It’s important to understand the components of the net credit sales formula:
- Gross credit sales include all sales that are not paid in cash.
- Sales allowances are reductions in the selling price of goods and services due to product defects or deficiencies. Sales allowances are deducted from gross credit sales.
- Sales returns are returns that a seller grants to the buyer in exchange for a full refund. Sales returns are also deducted from gross credit sales.
Gross credit sales minus sales allowances minus sales returns equals net credit sales.
How to calculate the accounts receivable turnover ratio
To calculate the ratio, determine the total dollar amount of net credit sales for the period. Note that customer purchases paid in cash are not part of the calculation.
Second, obtain the beginning and ending accounts receivable balances for the specific period used for the calculation. Higher accounts receivable balances often generate a low AR turnover ratio. Lower net credit sales also contribute to a lower ratio.
AR turnover ratio calculation example
Assume that Midwest Brands, a CPG company, has $3 million in net credit sales during the third quarter of 2023, and the average accounts receivable balance is $500,000. Midwest’s AR turnover ratio is ($3 million / $500,000), or 6.
In the 4th quarter of 2023, assume that Midwest’s net credit purchases total $4.5 million and the average accounts payable balance is $600,000. Midwest’s AR turnover ratio is ($4.5 million / $600,000), or 7.5.
To determine the correct KPI for your business, determine the industry average for the AR turnover ratio. A good accounts receivable turnover ratio depends on your industry’s sales cycle, the dollar amount of the average purchase, and other factors.
If you operate a seasonal business, the AR turnover ratio may have large fluctuations during a given period.
How to interpret the accounts receivable turnover ratio
A high accounts receivable turnover ratio indicates a stronger financial condition than a low accounts receivable turnover ratio. Generating a higher ratio improves short-term liquidity.
When a business can increase its AR turnover ratio, it indicates that it has more current assets available to pay current liabilities.
A liquidity ratio measures the company’s ability to generate sufficient current assets to pay all current liabilities, and working capital is a financial ratio to assess liquidity. Liquidity improves when managers collect cash quickly and carefully monitor cash outflows.
Working capital is calculated as (current assets less current liabilities), and management aims to maintain a positive working capital balance. In other words, businesses always want the current asset balance to be greater than the current liability total.
When Midwest increases the AR turnover ratio from 6 to 7.5, net credit sales increased by $1.5 million, while receivables increased by only $100,000.
The higher net credit sales in the 4th quarter may mean that total sales are higher (including both cash and credit sales). Higher sales may also drive more profit in the income statement.
Midwest has far more cash (a current asset) to pay for purchases in the 4th quarter than in the 3rd quarter. The company has better liquidity and a higher working capital balance.
If the AR turnover ratio declines, it may indicate financial distress. The business collects cash more slowly, reducing the cash inflows needed to pay current liabilities.
A decrease in the AR turnover ratio may be due to lower net credit sales, a higher average accounts receivable balance, or both. Businesses may see large fluctuations in the AR turnover ratio from one period to the next.
How to improve your accounts receivable turnover ratio
Consider credit checks, deposits, and other strategies to improve the AR turnover ratio to speed up collections.
Credit checks for new customers
New customers who do not have a payment history with your business may become slow-paying clients. To avoid this issue, many companies perform a credit check before doing business with a new customer.
This is a common practice for B2B firms but may not be practical for B2C companies with hundreds of retail customers. Assessing customers before offering payment terms is also time-consuming.
A company’s credit policy, however, can create tradeoffs. If your business has a conservative credit policy and does not offer credit terms to buyers, you will lose some potential sales. However, assessing a customer’s creditworthiness can help avoid incurring a bad debt expense.
Ask for deposits
You may ask for an initial deposit on each purchase if you sell large ticket items or produce customized products and services. Asking for a deposit signals whether or not the customer will pay on time. If you get customer pushback on deposits, it may be viewed as a red flag.
On the other hand, quality customers pay in a timely manner, which makes the collection process easier.
Automate the process
Make the payment process as seamless as possible. Send invoices electronically and give customers the option to pay invoices online. Many companies are automating accounts receivable, and your customers may use the same process with other vendors.
Accounting software can reduce the number of days needed to collect payments and improve the AR turnover rate. When you streamline the payment process, you may also drive repeat business.
Offer discounts for early payments
Perform a cash flow analysis and determine if offering discounts for early payment makes sense. For example, you might offer a 1% discount for payments made within ten days of the invoice date.
Getting 99% of the invoice paid within ten days may be more beneficial than waiting 30 days for 100% of the payment. If offering discounts helps you avoid borrowing funds from a line of credit to operate, you’re better off financially.
Track the number of times that customers take advantage of discounts. Experiment with changing the average number of days required to earn a discount and the percentage discount you offer. Your cash inflows will increase if you motivate customers to pay in a shorter timeframe.
Create a formal collection policy
Successful businesses have a formal process to follow up on late payments. For example, your firm may email customers when an invoice is 30 days old and call clients if an invoice reaches 45 days old. Non-responsive customers should be sent to collections for more follow-up.
Slow payments increase the accounts receivable balance and contribute to a low receivables turnover ratio.
The need to follow up with a customer is another red flag. If a client has to be contacted more than once regarding late payments, consider not doing business with them. The time and effort you spend following up on a late payment may not be worth the profit generated by the sale.
FAQs: AR turnover ratio
Here are some frequently asked questions and answers about the AR turnover ratio.
What's the difference between the AR turnover ratio vs. AP turnover ratio?
The accounts payable turnover ratio evaluates how well a company manages payments to vendors. The AR turnover ratio, on the other hand, measures how quickly a company collects payments and enforces collection policies. One ratio focuses on payables and the other on receivables.
The accounts payable turnover ratio is (net credit purchases) / (average accounts payable)
Credit purchases are those not paid in cash, and net purchases exclude returned purchases. The ratio measures how often a company pays its average accounts payable balance during an accounting period.
Both benchmarks are important metrics for assessing a company’s financial health.
Did you know? Our best AP automation software article provides pros and cons for 15 AP automation platforms, including Rho.
What does the accounts receivable turnover ratio measure?
The ratio measures how often a company collects its average accounts receivable balance in cash during an accounting period. Put another way, the ratio measures how quickly a business collects cash from credit sales.
Is a high AR turnover ratio good?
A high AR turnover ratio indicates better financial performance than a low ratio. A higher ratio strongly signals that the firm is quickly collecting cash from credit sales and that the average AR balance is manageable. A smaller average AR balance also improves the turnover ratio.
Wrap-Up: All about the AR turnover ratio
Monitoring the accounts receivable turnover ratio can help you make informed decisions about cash flow management and customer behavior. Well-managed businesses automate both receivables and payables to save time, reduce errors, and earn higher returns on excess cash.
Rho’s AP automation helps process payables in a single workflow — from invoice to payment — with integrated accounting.
- End-to-end functionality to manage AP and forecast cash flows
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- A scalable platform that grows as you grow
All wrapped up in unbeatable pricing and live customer support 24H Mon-Fri, 10-7pm ET on weekends sounds nice to you,
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Competitive data was collected as of February 7, 2024, and is subject to change or update.
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