If you're a small business owner, you probably already know that proper bookkeeping is critical for keeping your business on track. Not only does it facilitate accurate accounting, but it can also provide you with the data you need to track your business's financial health. Products like Skynova's accounting software can go a long way in helping streamline the process.
Accounts receivable turnover is one of many metrics and financial ratios that can be calculated from your business's financial data. In this article, we cover what it is, how to calculate it, why it's important, and how it can inform business decisions.
How Do You Calculate Accounts Receivable Turnover?
The first step toward understanding accounts receivable turnover (AR turnover) is to understand how to calculate it. Here, we break down the calculation process so you can get started right away.
Calculating the accounts receivable turnover ratio formula requires taking the net credit sales over a period and dividing that figure by the average accounts receivable figure over that same period:
|Accounts Receivable Turnover|
To help you out, we've broken this calculation down into steps and included examples.
Step 1: Choose Your Accounting Period
You must first define the period of time over which you will perform your ratio analysis. You may choose to calculate it on an annual, quarterly, or monthly basis, or over any number of days. It's important to establish what the period is and what the beginning and ending days are so you can find the right numbers and your calculation can give you accurate results.
For example, suppose you would like to track accounts receivable on a quarterly basis. You would use data from Jan. 1 through March 31 for the first quarter, from April 1 through June 30 for the second quarter, and so on. If you wanted to compute annually, you would use data from the entire year.
Step 2: Calculate Your Net Credit Sales
The net credit sales are a key input into the formula. A credit sale is any sale that was made on credit. This doesn't mean credit card sales, but any sales made for which you didn't receive immediate customer payment and have payment due later (usually within seven to 30 days or so, depending on your company's credit terms ).
To find your net credit sales, review your financial statements for the specified period. Compute your total sales then subtract noncredit transactions (e.g., cash sales) and any returns or cancellations. For example, if your total sales for the year were $120,000 but $70,000 was from cash sales or other noncredit transactions, and $5,000 worth of credit sales was returned, your net credit sales for the quarter would be $120,000 - $70,000 - $5,000 = $45,000.
Step 3: Calculate Your Average Accounts Receivable
This next step will help you calculate your average accounts receivable. First, note that your company's accounts receivable are the total unpaid money due to the company from sales that have been made. In other words, it can be thought of as the total outstanding debt owed to you by your customers.
The simplest way to calculate the average accounts receivable for a specified period is to take the sum of beginning accounts receivable and ending accounts receivable and divide them by two. The beginning accounts receivable is the total accounts receivable balance on the first day of the period and the ending accounts receivable is the total ending balance on the last day of the period.
|Average Accounts Receivable|
Alternatively, you could figure out a daily average for the entire period. This might be worth doing if your beginning and ending numbers are not representative of typical values for whatever reason.
For example, suppose you want to find your average accounts receivable for the year. They totaled $5,000 at the beginning of the year and $7,000 at the end of the year. So, your average would be ($5,000 + $7,000)/2 = $6,000.
Step 4: Complete the Accounts Receivable Turnover Formula
At this point, you have all the numbers you need to perform the calculation. Recall that the formula is:
|Accounts Receivable Turnover|
Let's assume for the period of one year that the net credit sales made were $45,000 and the average accounts receivable balance was $6,000. The AR turnover ratio (also sometimes called the debtors turnover ratio ) is:
|Accounts Receivable Turnover|
Note that because it is a ratio, it is a unitless quantity. The follow-up is analyzing the results to determine what it says about your business and then devising an action strategy based on the results.
Why Is Accounts Receivable Turnover Important?
The accounts receivable turnover ratio is an accounting method used to quantify how effectively a business extends credit and collects debts on that credit, so it's very important to understand and know how to calculate it.
It can be understood in more detail by taking a close look at the formula. The numerator in the formula is the net sales made on credit. Making sales on credit is inherently risky because there's always a chance that customers won't pay up and you could be taking on bad debt - which can hurt your bottom line.
However, if your company collects payments reasonably quickly so the accounts receivable is never too high or the average collection period doesn't drag out with many past due or late payments being made, your company is extending credit to customers wisely. This is where the numerator in the formula comes in. The net credit sales are divided by the average amount of unpaid accounts.
You can think of the ratio number as a measure of the number of times your company collects its receivables during the specified period. In other words, an AR turnover ratio of 7.5 for the year indicates that receivables are converted to cash 7.5 times per year. In other words, it takes 365/7.5 = 48.7 days, on average, for customers to pay on credit sales.
What Is a Good Accounts Receivable Turnover Ratio?
Ideally, you want to look at your AR ratio number and get an immediate sense of how well your business is doing. You may have surmised that higher ratios tend to be better, but this isn't always true. Below are more details on how to interpret the ratio.
High Receivable Turnover
A high accounts receivable turnover ratio suggests that the company collects payments on time more often than not, which is good. The company's collection of accounts receivable is efficient, and the company has a high proportion of quality customers who pay their debts quickly.
However, a really high ratio might indicate that you could stand to extend more credit to customers and could potentially be missing out by not doing so. Carefully consider your business's need for working capital and your overall cash flow situation first. If your AR turnover ratio is extremely high, it might be time to consider a less conservative credit policy to open up more opportunities for sales.
Low Receivable Turnover
A low accounts receivable turnover ratio indicates that a greater proportion of extended credit is going unpaid or is paid late. Low receivable turnover ratios might be due to a poor collection process, bad credit policies, or customers who aren't financially viable or creditworthy. It's worth devoting some time to figuring out what might be the cause and change business practices accordingly.
How to Improve Accounts Receivable Turnover
Consider setting a goal for an optimal accounts receivable turnover ratio range. For example, perhaps your company thinks the ratio should range between eight and 12 annually because this corresponds to an average time for repayment of 15 to 30 days.
If the number dips below this, you can try one or more of the following strategies:
- Requiring more extensive credit checks
- Changing due dates to earlier dates
- Imposing late fees on past-due balances
- Requiring more items be paid for upfront
If the number gets too high, you might try:
- Offering extended payment plans on big-ticket items to encourage more customers to buy on credit
- Offering discounts to purchases made on credit
- Loosening your requirements for credit sales
- Reducing late fees and penalties
Let Skynova Help You Improve Your Accounts Receivable
Running a small business is a huge responsibility, and there is a lot to keep track of. Skynova's accounting software provides all-in-one invoicing and accounting specially designed for small businesses like yours. You can also check out Skynova's multiple other products and templates to simplify the process of running your small business.