Accounts receivable management is not for the faint of heart. AR professionals are responsible for collecting money that customers, suppliers, or other entities owe their company. If the payer does not send funds to your organization in a timely manner, it could jeopardize your entire business. Businesses cannot provide goods or services without receiving payment for them; That’s one of the first aspects of doing business.
Tracking the time it takes for customers to pay their invoice is a key reporting priority within the accounts receivable function. The AR team must know if a payer is behind on payments, if contract terms are not being met, or if the client’s line of credit needs to be adjusted or eliminated entirely.
One of the main calculations made by AR experts – which play a different role than your AP team – support yourself when making these decisions is the Accounts receivable turnover ratio. If you don’t recalculate your accounts receivable turnover ratio regularly, you leave your company exposed to unnecessary vulnerabilities and risks. Fortunately, using the accounts receivable ratio turnover formula in your business is quite simple and can be implemented right away.
What is accounts receivable turnover ratio?
The accounts receivable turnover ratio shows how many times your organization successfully collects the average balance in the accounts receivable section of your balance sheet. This is money that is owed to you and it is essential that invoices are settled periodically.
Basically, you can think of the AR as a line of credit; You will not keep credit extended if a customer does not pay you in a timely manner. While you might think that you will never deal with a difficult customer who doesn’t pay what they owe, the fact is that there are many companies and individuals who will force you to strengthen your relationship with them because of this. very problem.
Likewise, it is important that your organization optimize the supplier payment process For suppliers, you want to collect payments seamlessly when you play the role of supplier. The more efficient your company is at managing accounts receivable turnover, the higher the ratio will be. Keep in mind that accounts receivable turnover depends on the industry you are in. In some industries, it is normal to have net 30 payment terms with customers, while in others, customers may have a longer window to repay credit extended to them. Since these factors will affect your accounts receivable turnover ratio, you only need to compare your output to other companies in your industry – your competitors.
When to use the accounts receivable turnover ratio
The accounts receivable turnover formula should be used periodically at specific time intervals. Many companies calculate their AR turnover rate monthly, quarterly, and annually to get an idea of how efficient their AR process is. The turnover rate can be calculated at a general, holistic level, or it can be used at the individual customer level to isolate delinquent customers and the rate at which they have been paying their balance.
Accounts Receivable Turnover Formula
To get an accurate accounts receivable turnover ratio, you need to know the average net credit sales and accounts receivable within the period you are measuring.
- Net Credit Sales: The amount of revenue your company has earned through credit will end up being the net amount of credit sales, your numerator when calculating the accounts receivable turnover ratio. You must subtract any sales discounts or customer returns from the net credit sales figure within that specific period to get an accurate starting point.
- Average accounts receivable: At the bottom of the equation, the denominator, will be the average accounts receivable. This is the result of adding the ending accounts receivable balance to the beginning accounts receivable balance and dividing it by 2.
In terms of formula, use the following equations for the accounts receivable ratio turnover formula:
- Net credit sales = Gross Credit Sales – Refunds or Returns
- Average accounts receivable = (Initial AR Balance + Ending AR Balance) / 2
- Accounts receivable turnover ratio = (Net Credit Sales / Average Accounts Receivable)
- AR turnover in days = 365 / Accounts receivable turnover ratio
With the formulas above, your organization can better forecast the flow of funds that will come into your business. These funds can then be used to cover business expenses, strategic investments, or other financial commitments. Let’s see how this calculation works out in practice:
- Your company has net credit sales of $600,000 per year after accounting for all rebates and discounts.
- Your beginning AR balance was $75,000 and your ending AR balance for the period was $60,000. This means your average accounts receivable is (75,000 + 60,000) / 2 = $67,500.
- With this information, you can calculate your accounts receivable turnover ratio. $600,000 / $67,500 = 8.89
Interpretation of the accounts receivable turnover ratio
Deciding whether your accounts receivable turnover ratio is “good” can be quite nuanced. Accounts receivable turnover ratio results will vary depending on a variety of factors. All of the following elements can affect the production of the ratio within a period:
- Industry standards for payment terms
- The credit policies your organization has
- Economic volatility
- Customer behavior
When evaluating accounts receivable turnover ratio results, be sure to consider the context of the above items in your evaluation.
High versus low AR turnover ratio
When it comes to accounts receivable turnover ratio, the higher the better. In the example above, the company in question converted its accounts receivable into cash 8.89 times in a single year. If you divide 365 / 8.89, you can see that it took an average of 41.06 days to collect funds from customers. If your payment terms are N30, you should tighten your credit policies with your customers and, if possible, aim for a 30-day billing result.
If your accounts receivable turnover ratio is low, it means you are not collecting your debts often enough. When not collected, debts affect your company’s liquidity and ability to operate. Training your accounts receivable team can be a huge help in recovering payments on overdue invoices.
Ideal AR turnover ratio
As mentioned, the result of an accounts receivable turnover ratio formula can vary widely, as can your company’s tolerance for these fluctuations. Ideally, your accounts receivable turnover ratio in number of days should match your net payment terms. If most of your payment terms are N30, look for an AR turnover rate of 10 to 12, which indicates that you collect payments every 30 to 36 days on average.
Limitations of the accounts receivable turnover ratio
Data without context is just as useful as no data, and accounts receivable turnover is no different. When analyzing this metric, be sure to look at metrics that measure your liquidity, your overall sales, and your collections process, all of which will give more context to the number at the end of the accounts receivable turnover ratio formula.
If your business relies on subscriptions or cyclical payments with many different customers, your ratio could end up being a poor representation of the overall collections process. Accounts receivable turnover also does not take into account extenuating circumstances that your customers may face that would cause them to fall behind on their payments. Perhaps a warehouse fire or cybersecurity attack is impeding your ability to pay on time; These cases are unique and will normally recover in the following period.
Improve your accounts receivable turnover ratio
If your organization continues to see a low accounts receivable turnover rate, it’s time to make a change. It can be a little awkward to change payment terms or collection policies with your client, but sometimes it’s necessary. Try some combination of the following items if you’re not sure where to start:
- Reduce payment terms with clients. If your customers continue to pay after their invoices are due, adjust the line of credit you offer them. Instead of allowing them to pay an invoice within 60 days, shorten it to 30 or even 15 days. If customers are repeat offenders and consistently miss payments, consider signing them up with a prepaid contract. Your payment terms should appear clearly on each invoice sends, ensuring that there are no communication problems on either party.
- Impose late payment fees or early payment discounts. People don’t want to pay extra fees, so if they sign a contract that tells them a 10% late fee will be added to invoices that aren’t paid on time, they’ll be willing to give you their cash. On the other hand, you might decide to reward your customers who continue to pay early. Offering a 5% discount for early payments could solidify your organization’s ability to collect invoices with ease.
- Send payment reminders. You’ll be surprised how effective this can be. Sometimes customers will be busy and forget to send a payment. A few emails throughout the month as the invoice due date approaches is a perfect way to encourage them to pay you.
- build a automated payment infrastructure for your clients. If you offer services, consider having an automatic payment option. This way, your clients won’t have to manually send payments and instead, with their permission, you can collect funds automatically. In the same way that automate the billing process on the sender side can improve AP productivity, task automation on the AR side will improve upstream and downstream workflows.
The accounts receivable turnover formula can be difficult to optimize, but with a few key tricks, your organization could go from struggling with accounts receivable to seeing an exponential increase in the number of invoices settled on time.
<h2 id="using-technology-to-improve-the-ar-turnover-ratio”>Using technology to improve AR churn rate
An efficient and effective automated billing process will improve the AR turnover rate of any business. If you feel that the current resources available for your AR equipment are not sufficient, consider investing in a software solution like Nanonets that can revolutionize the way your entire accounting and finance team operates. With simplified invoice matching, the use of robotic process automation, and error-free processes, the right software can make a big difference.
