Accounts Receivable Turnover ratio indicates how many times the accounts receivables have been collected during an accounting period. It can be used to determine if a company is having difficulties collecting sales made on credit. The higher the turnover, the faster the business is collecting its receivables. It can be expressed in many forms including accounts receivable turnover rate, accounts receivable turnover in days, accounts receivable turnover average, and more.
Accounts Receivable Turnover Meaning
Accounts receivable turnover measures how efficiently a company uses its asset. It is an important indicator of a company's financial and operational performance. Many companies even have an accounts receivable allowance to prevent cash flow issues.
A high accounts receivable turnover indicates an efficient business operation or tight credit policies or a cash basis for the regular operation.
A low or declining accounts receivable turnover indicates a collection problem from its customer. Also, there is an opportunity cost of holding receivables for a longer period of time. Company should re-evaluate its credit policies to ensure timely receivable collections from its customers.
Accounts Receivable Turnover Formula
A profitable accounts receivable turnover ratio formula creates survival and success in business. Phrased simply, an accounts receivable turnover increase means a company is more effectively processing credit. An accounts receivable turnover decrease means a company is seeing more delinquent clients. It is quantified by the accounts receivable turnover rate formula.
Accounts Receivable Turnover = Annual credit sales / Average accounts receivable
Accounts Receivable Turnover Calculation
Average Accounts Receivable is the average of the opening and closing balances for Accounts Receivable.
In real life, sometimes it is hard to get the number of how much of the sales were made on credit. Investors can use total sales as a shortcut. When this is done, it is important to remain consistent if the ratio is compared to that of other companies.
Example: assume annual credit sales are $10,000, accounts receivable at the beginning is $2,500, and accounts receivable at the end of the year is $1,500.
The accounts receivable turnover is: 10,000 / ((2,500 + 1,500)/2) = 5 times
Accounts Receivable Turnover Example
To emphasize it's importance we will provide an accounts receivable turnover ratio example. Many companies live and die by collections. These rates are essential to having the necessary cash to cover expenses like inventory, payroll, warehousing, distribution, and more.
Manufactco is a company that manufactures widgets. Manufactco's widgets have become very popular. The company is growing quickly and must hire new employees for their plant.
Annual Credit Sales: $10,000
Accounts Receivable in 1/1/09: $2,500
Accounts Receivable in 12/31/09: $1,500
Currently, Manufactco's accounts receivable turnover rate is:
$10,000/ (($2,500 + $1,500)/2) = 5 times
Every company should have someone tasked as, amongst other bookkeeping matters, head accounts receivable turnover calculator. This person is known as a Chief Financial Officer; a CFO. She has found that a full turnover happens 5 times in one year. To rephrase, in a full year all open accounts receivable are collected and closed 5 times. This is the accounts receivable turnover ratio meaning.
Now let's make things a bit more complicated. How many accounts receivable turnover days will it take to complete one cycle?
Simply use this formula:
Days Receivable Outstanding = # of days / accounts receivable ratio calculation
Many companies Google "accounts receivable turnover ratio calculator", look towards their BA II, or scour their local bookstore. A properly trained CFO, however, has the answers to this and many other questions.
The period for this example begins at 1/1/09 and ends at 12/31/09. The number of days for this period, then, would be 365. Manufactco's accounts receivable equation for the number of days a receivable is outstanding is:
365 days / 5 times = 73 days for AR to turnover
This means that all open accounts receivable are collected and closed every 73 days. In 73 days customers make a purchase, are reminded that payment is due, send payment, have payments processed, and have receivable accounts closed.
The Chief Financial Officer of Manufactco now knows that 5 full turnovers happen in a year. She also knows that it takes 73 days for one full turnover to occur. Creating a profitable company is now a simple matter.
Tightening credit policies is one common method. Options include decreasing the amount of days allotted before payment is due, including or increasing discounts for early payment, or increasing the late payment penalty fee. Additionally, she could update collections technologies or simply increase collections staff. In extreme conditions Manufactco could even stop serving certain customers, in effect "firing" those who are late or non-paying. All of these tools are available for the clever CFO.
Reprinted with permission from www.WikiCFO.com