Understanding Accounts Receivable Turnover
Business owners have a lot to keep track of, and if you sell goods or services on credit, you can add accounts receivable turnover to the list.
Simply put, accounts receivable is money owed to a business for products delivered or services performed, Helena Swyter, owner of SweeterCPA in Chicago, said. Accounts receivable turnover measures how effective a company is at using credit and collecting on debt.
The accounts receivable turnover formula
Knowing your turnover ratio is important because it can tell you several things about your business. For example, it can help you understand if you’re collecting on your outstanding credit debt in a timely manner. Failure to do so leave you with less available cash flow for your business.
To figure out your accounts receivable turnover — sometimes called accounts receivable turnover ratio — use the following formula:
Net Annual Credit Sales ÷ (Beginning Accounts Receivable + Ending Accounts Receivable)/2)
Your net credit sales are the sales your company has made on credit (customer payments by credit cards or lines of credit you extended to them). Sales by cash or check don’t enter into this equation because the point of the formula is to measure how well your company uses credit, Swyter said.
To find your average accounts receivable, take the total value of all your accounts receivable at the beginning of a given period and add it to the total accounts receivable at the end of a given period — and divide that number by 2. Let’s say your company has net credit sales of $875,000 for a 12-month period and your accounts receivable (outstanding sales) at the beginning of the year was $150,000 and $100,000 at the end of the year. Now plug those numbers into the formula:
Accounts receivable turnover = $875,000 net credit sales/$150,000 beginning year accounts receivable +$100,000 end of year accounts receivable)/2)
Your accounts receivable turnover equals 7, meaning you’re collecting on your outstanding credit sales seven times a year, or roughly every 52 days. How often you should collect on your accounts receivable varies among industries. For example, a company with a longer processing or delivery window will have a lower ratio than one selling readymade products, Swyter said. A furniture store is likely to have a low ratio due to the length of time that occurs from sale to delivery and also because you’ll likely have a high volume of customers paying with credit based on the high cost of furniture.
What does your ratio mean?
Now that you’ve figured out your accounts receivable turnover, you need to understand what it means. In general, the higher your score, the better, although a high score could be a sign of some problems. Let’s take a look at what happens when you have a high and low ratio of accounts receivable turnover:
- You have strong cash flows, which decreases the chances your company will have to write off bad debt.
- Your credit policy and collections practices are working for you.
- Your customers are paying off their debt quickly, which means you’re giving credit to the right kind of customers.
- On the negative side, this could mean you do a majority of your sales on credit, which could impact your cash flow and make it hard to keep up with expenses.
- A very high score also could mean your credit collection process is too forceful, which might eventually turn off customers. “There’s a line between efficient and aggressive credit collections,” Swyter said. “Customers who feel hassled to pay off lines of credit early might take their future business elsewhere.”
You can’t write off bad debt if you use the common cash method of accounting. For tax purposes, this method only counts income when it’s received and expenses when they occur, Swyter said. “Since you never received the income from the unpaid invoice, there’s nothing to write off,” she said. If you use the accrual method of accounting, however, you can write off bad debts. Accrual accounting involves recording the revenues and expenses when they happen, regardless of when cash is exchanged.
- You’re extending credit to customers who are frequently paying late.
- Your company’s cash flows could be hurt by the late payments.
- Your credit policies, credit application and/or your payment collections process might not be working well.
You should use your accounts receivable turnover ratio to determine if you need to change how your company is extending credit and collecting on invoices. If your ratio is low, take a close look at your credit approval and collections process, Swyter said. Then ask yourself the following questions:
- Are the customers with outstanding balances creditworthy?
- How are clients approved for lines of credit?
- Are you charging interest for late payments? If not, should you be?
- Is there a process to reduce or remove those credit lines if payments are late?
- If your collections process is strong, are there other factors that could be causing the low ratio? For example, perhaps your customers aren’t receiving their products — or are receiving them late or damaged. “These lags in delivery will add time to the payment process,” Swyter said.
Make sure it’s a good thing if you have a high ratio. If you discover you have a lot of customers paying with credit, you might want to increase your cash flow by giving customers an incentive, such as a discount, to pay in cash or to pay an invoice early.
Along with retaining customers and creating positive cash flow, your accounts receivable turnover can also be important if you need to get a small business loan. It’s something lenders will look at, Swyter said, because it signals whether your business will be profitable in the future.
Accounts receivables turnover: be careful
Although the accounts receivable ratio is a fairly good indicator of your company’s use of credit, there are some factors that can make it misleading. Regardless of your ratio, it’s always a good idea to check your company’s credit policies and collection processes as well as other parts of the business, such as delivery and quality control. Here are some cautionary items to consider:
- Customers who have high balances but pay quickly might mean you have a large number of outstanding accounts with smaller balances, which can skew the ratio.
- One of the most common errors people make in figuring their accounts receivable turnover ratios is including cash sales instead of only credit sales in the numerator, Swyter said. “Cash sales inflate the numerator and distort the result,” she said.
- The beginning and ending accounts receivable balances are for two specific points in time during the measurement year, so the balances on those two dates might vary drastically from the average amount during the entire year. It’s acceptable to use the average ending balance for the entire year.
- Don’t forget about your accounts receivable aging, which shows the age of your outstanding payments. Make sure you break your data out into subgroups based on ranges — such as invoices that are less than 30 days old and invoices that are between 31 to 60 days old — Swyter said. “As debt ages, it’s less likely to be collected, so a business with a large amount of old debt could be facing some immediate cash flow problems,” she said.
The bottom line
Figuring out your accounts receivable turnover is a good way to spot problems in your business’ credit and collections process, which in turn can improve your cash flow. You want to strive for a high turnover rate, but even if you achieve that, make sure your credit policies are in line with your competitors’ so you don’t lose any business. If you have a very low rate, it’s time to make some changes to your policies and credit collection process. This will give you a leg up on maintaining a healthy business — or even growing it.