Definition of Accounts Receivable Turnover
Accounts Receivable Turnover can be defined as the number of times on a yearly basis that a company collects its accounts receivables. This metric is used to measure the extent to which companies collect periods from their customers.
Receivable Turnover is an accounting measure that is used to gauge the overall effectiveness of the company when it comes to collecting its accounts receivables, or money that is owed by customers or clients of the business.
Therefore, this ratio is directed towards measuring how well an organization uses and manages credit that is given to customers and how quickly short-term debt is collected or paid by the company. Generally speaking, firms that have a better collection policy will have higher accounts receivable turnover ratios.
Therefore, Accounts Receivable Turnover can be described as a metric that helps companies to devise their credit policies, in line with the type of industry, and their own liquidity cycle.
It is important to have a clear understanding of what they actually require so that there are no issues on the behalf of the company in meeting their day-to-day expenses. This ratio is mostly calculated by managerial accountants to check for changes required in the credit policy of the company.
The formula of Accounts Receivable Turnover
Accounts Receivable Turnover is calculated using the following formula:
Accounts Receivable Turnover = Net Credit Sales for the given period / Average Accounts Receivable in the given year
In the formula above, average receivables are calculated as follows:
Average Accounts Receivables = (Beginning Accounts Receivable + Ending Accounts Receivable) / 2
Similarly, Net Credit Sales are calculated as follows:
Net Credit Sales = Sales on Credit – Sales Returns – Sales Allowances
The ratio above helps businesses in getting an understanding regarding debt collection policy, and it needs to be changed in order to improve the cash flow position of the business.
Example of Accounts Receivable Turnover
The concept of Accounts Receivable Turnover is illustrated in the following example:
High-Fi Co. is a wholesaler that sells goods on credit to various retailers. The amount that is extended as credit to the retailers are recorded as Accounts Receivable for the company. On 1st January 2019, High-Fi Co. had an Accounts Receivable Balance worth $10,000.
However, on 31st December 2019, the ending balance was $30,000. During the year ended 31st December 2019, Net Credit Sales for High-Fi Co. amounted to $50,000.
Slow-Mo Co., a competitor of High-Fi Co. had an Average Accounts Receivable Turnover Ratio of 20.
In the example mentioned above, it can be seen that the Accounts Receivable Turnover of High-Fi Co. can be calculated as follows:
Average Accounts Receivables = (Beginning Accounts Receivables + Ending Accounts Receivables) / 2
Average Accounts Receivables = ($10,000+$30,000)/2 = $20,000
Accounts Receivable Turnover = Net Credit Sales for the given period / Average Accounts Receivable in the given year
Accounts Receivable Turnover = $500,000 / $20,000 = 25
In comparison to Slow-Mo Co.’s Accounts Receivable Turnover of 20, it can be seen that High-Fi Co.’s Accounts Receivable Turnover is better.
Accounts Receivables Turnover in days
In order to calculate Accounts Receivable Turnover in days, the Accounts Receivable Turnover metric simply needs to be divided across the number of days in a calendar year.
Therefore, the formula for Accounts Receivable Turnover in days would be equivalent to:
Accounts Receivable Turnover in Days = 365 / Accounts Receivable Turnover
In the illustration mentioned above, it can be seen that Accounts Receivable Turnover in Days can be calculated as follows:
Accounts Receivable Turnover = 365 / 25 = 18.25 days
This implies that on average. 18.25 days are taken for Accounts Receivables to be settled. In other words, debtors take around 18.25 days in order to settle the given debt.
Interpretation of Accounts Receivable Turnover
As mentioned earlier, it can be seen that accounts receivable turnover helps companies to gauge the efficiency of the debt collection process that the company entails. Lower numbers for Accounts Receivable Turnover are generally perceived to be more efficient as compared to higher numbers.
This is primarily because of the fact that it shows that the company works well in ensuring that its credit limit is well defined enough to not have a detrimental impact on the cash flow position of the business.
In the same manner, if the company has higher turnaround times for debt collection (i.e. Accounts Receivables), it implies that the company has a relatively easier credit policy, and it might not work out well for the company in terms of collecting revenue.
Additionally, it might also have a detrimental impact on the ability of the company to meet its day-to-day operations.
This can be summarized as follows:
- High Receivables Turnover Ratio as compared to industry standards: A high receivables turnover ratio in comparison to industry average implies that the credit policy of the company is sorted, and there is a high proportion of customers who pay their debt quickly to the company.
- Low Receivables Turnover Ratio as compared to industry standards: A low receivables turnover ratio as compared to industry average requires the company to adjust their credit policy, and enforce a strict credit check before extending credit to customers.
Industry Average for Accounts Receivable Turnover
Generally speaking, there is no high or low threshold for Accounts Receivable Turnover. For some industries and lines of businesses, a high accounts receivable turnover is the norm.
On the contrary, for other businesses, low accounts receivable might be common.
For example, industries that generally have a higher cash conversion cycle are known to have low Accounts Receivable Turnover. This might be primarily because of the nature of the business itself.
The restaurant industry, for example, does not require long credit cycles, since customers pay upfront for the goods and services they are selling. On the other hand, some business types also require delayed cash conversion cycles.
Majorly, these are businesses are the ones that require a longer time duration from the first step of production, till the last step of the production cycle.
Therefore, depending on the industry that is involved, as well as other standards, Accounts Receivable Turnover varies from one industry to another. There is no optimal ‘average’ that companies should target, but there is a threshold that should be kept in mind when it comes to deciding the credit policy.
When making these decisions, the main course of action of businesses is to ensure that the companies are able to ensure that their operational efficiency isn’t compromised as a result of their credit sales.
Hence, they should ensure that their cash conversion cycle is reduced so that the ability of the company to meet its day-to-day expenses is not compromised upon.
