Receivables Turnover Ratio Defined: Formula, Importance, Examples, Limitations

What Is the Accounts Receivables Turnover Ratio?

The accounts receivables turnover ratio measures the number of times a company collects its average accounts receivable balance. It is a quantification of a company's effectiveness in collecting outstanding balances from clients and managing its line of credit process.

An efficient company has a higher accounts receivable turnover ratio while an inefficient company has a lower ratio. This metric is commonly used to compare companies within the same industry to gauge whether they are on par with their competitors.

Understanding Receivables Turnover Ratios

Accounts receivable are effectively interest-free loans that are short-term in nature and are extended by companies to their customers. If a company generates a sale to a client, it could extend terms of 30 or 60 days, meaning the client has 30 to 60 days to pay for the product.

The receivables turnover ratio measures the efficiency with which a company is able to collect on its receivables or the credit it extends to customers. The ratio also measures how many times a company's receivables are converted to cash in a certain period of time. The receivables turnover ratio is calculated on an annual, quarterly, or monthly basis.

Formula and Calculation of the Receivables Turnover Ratio

The accounts receivable turnover ratio is the relationship between net credit sales and average accounts receivable:

Net Credit Sales

The numerator of the accounts receivable turnover ratio is net credit sales, the amount of revenue earned by a company paid via credit. This figure include cash sales as cash sales do not incur accounts receivable activity. Net credit sales also incorporates sales discounts or returns from customers and is calculated as gross credit sales less these residual reductions.

It is important that the calculation uses a consistent timeframe. Therefore, the net credit sales should only incorporate a specific period (i.e. net credit sales for the second quarter only). Should returns happen in a future period, this figure should be included in the calculation as it relates to the activity being analyzed.

Average Accounts Receivable

The denominator of the accounts receivable turnover ratio is the average accounts receivable balance. This is usually calculated as the average between a company's starting accounts receivable balance and ending accounts receivable balance.

Companies with more complex accounting information systems may be able to easily extract its average accounts receivable balance at the end of each day. The company may then take the average of these balances; however, it must be mindful of how day-to-day entries may change the average. Similar to calculating net credit sales, the average accounts receivable balance should only cover a very specific time period.

High vs. Low Receivables Turnover Ratio

High Ratios

A high receivables turnover ratio can indicate that a company’s collection of accounts receivable is efficient and that it has a high proportion of quality customers who pay their debts quickly. A high receivables turnover ratio might also indicate that a company operates on a cash basis.

A high ratio can also suggest that a company is conservative when it comes to extending credit to its customers. Conservative credit policies can be beneficial since they may help companies avoid extending credit to customers who may not be able to pay on time.

On the other hand, having too conservative a credit policy may drive away potential customers. These customers may then do business with competitors who can offer and extend them the credit they need. If a company loses clients or suffers slow growth, it may be better off loosening its credit policy to improve sales, even though it might lead to a lower accounts receivable turnover ratio.

Low Ratios

A low receivables turnover ratio isn't a good thing. That's because it may be due to an inadequate collection process, bad credit policies, or customers that are not financially viable or creditworthy. A low turnover ratio typically implies that the company should reassess its credit policies to ensure the timely collection of its receivables. However, if a company with a low ratio improves its collection process, it might lead to an influx of cash from collecting on old credit or receivables.

In some cases, though, low ratios aren't always bad. For example, if the company's distribution division is operating poorly, it might be failing to deliver the correct goods to customers in a timely manner. As a result, customers might delay paying their receivables, which would decrease the company’s receivables turnover ratio.

Importance of Receivables Turnover Ratio

The accounts receivable turnover ratio communicates a variety of useful information to a company. The ratio tells a company:

• How well a company is collecting credit sales. As a company processes receivable balances faster, it gets its hand on capital faster.
• What collateral opportunities a company may have. Some lenders may use accounts receivable as collateral; with strong historical accounts receivable activity, a company may have greater opportunities to borrow funds.
• When it might be able to make large capital investments. A company can project what cash it will have on hand in the future when better understanding how quickly it will convert receivable balances to cash.
• How sufficiently a company is evaluating the credit of clients. If a company's accounts receivable turnover ratio is low, this may be an indicator that a company is not reviewing the creditworthiness of its clients enough. Slower turnover of receivables may eventually lead to clients becoming insolvent and unable to pay.
• How it is performing over time. When analyzing financial ratios of a single company over time, that company can better understand the trajectory of its accounts receivable turnover.
• How it is performing compared to its competitors. When analyzing financial ratios of several different but similar companies, a company can better understand whether it is an industry-leader or whether it is falling behind.

Usefulness of the Accounts Receivables Turnover Ratio

Like other financial ratios, the accounts receivable turnover ratio is most useful when compared across time periods or different companies. For example, a company may compare the receivables turnover ratios of companies that operate within the same industry. In this example, a company can better understand whether the processing of its credit sales are in line with competitors or whether they are lagging behind its competition.

When making comparisons, it's ideal to look at businesses that have similar business models. Once again, the results can be skewed if there are glaring differences between the companies being compared. That's because companies of different sizes often have very different capital structures, which can greatly influence turnover calculations, and the same is often true of companies in different industries.

Another example is to compare a single company's accounts receivable turnover ratio over time. A company may track its accounts receivable turnover ratio every 30 days or at the end of each quarter. In this manner, a company can better understand how its collection plan is faring and whether it is improving in its collections.

Limitations of the Receivables Turnover Ratio

The receivables turnover ratio is just like any other metric that tries to gauge the efficiency of a business in that it comes with certain limitations that are important for any investor to consider.

Some companies use total sales instead of net sales when calculating their turnover ratio. This inaccuracy skews results as it makes a company's calculation look higher. When evaluating an externally-calculated ratio, ensure you understand how the ratio was calculated.

Another limitation is that accounts receivable varies dramatically throughout the year. This is often the case with seasonal companies. These entities likely have periods with high receivables along with a low turnover ratio and periods when the receivables are fewer and can be more easily managed and collected.

As such, the beginning and ending values selected when calculating the average accounts receivable should be carefully chosen to accurately reflect the company's performance. Investors could take an average of accounts receivable from each month during a 12-month period to help smooth out any seasonal gaps.

Example of Receivables Turnover Ratio

Let's say Company A had the following financial results for the year:

• Net credit sales of $800,000.
• $64,000 in accounts receivables on Jan. 1 or the beginning of the year.
• $72,000 in accounts receivables on Dec. 31 or at the end of the year.

We can calculate the receivables turnover ratio in the following way:

$\begin{aligned} &\text{ACR}=\frac{\$64,000+\$72,000}{2}=\$68,000\\ &\text{ARTR}=\frac{\$800,000}{\$68,000}=11.76\\ &\textbf{where:}\\ &\text{ACR = Average accounts receivable}\\ &\text{ARTR = Accounts receivable turnover ratio}\\ \end{aligned}$​ACR=2$64,000+$72,000​=$68,000ARTR=$68,000$800,000​=11.76where:ACR = Average accounts receivableARTR = Accounts receivable turnover ratio​

We can interpret the ratio to mean that Company A collected its receivables 11.76 times on average that year. In other words, the company converted its receivables to cash 11.76 times that year. A company could compare several years to ascertain whether 11.76 is an improvement or an indication of a slower collection process.

A company could also determine the average duration of accounts receivable or the number of days it takes to collect them during the year. In our example above, we would divide 365 by 11.76 to arrive at the average duration. The average accounts receivable turnover in days would be 365 / 11.76, which is 31.04 days.

For Company A, customers on average take 31 days to pay their receivables. If the company had a 30-day payment policy for its customers, the average accounts receivable turnover shows that, on average, customers are paying one day late.

A company could improve its turnover ratio by making changes to its collection process. A company could also offer its customers discounts for paying early. Companies need to know their receivables turnover since it is directly tied to how much cash they have available to pay their short-term liabilities.

The Bottom Line

The accounts receivable turnover ratio measures the number of times a company's accounts receivable balance is collected in a given period. A high ratio means a company is doing better job at converting credit sales to cash. However, it is important to understand that factors influencing the ratio such as inconsistent accounts receivable balances may accidently impact the calculation of the ratio.