The Accounts Receivable Turnover is a working capital ratio used to estimate the number of times per year a company collects cash payments owed from customers who had paid using credit.
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The accounts receivable turnover ratio, or “receivables turnover”, measures the efficiency at which a company can collect its outstanding receivables from customers.
On the balance sheet, accounts receivable (A/R) represents the unmet payment obligations by customers, so the quick retrieval of owed cash payments implies the company can efficiently manage the credit extended to customers.
Tracking the receivables turnover is crucial for companies, because an increase in accounts receivable means more free cash flows (FCFs) are tied up in operations.
In effect, the amount of real cash on hand is reduced, meaning there is less cash available to the company for reinvesting into operations and spending on future growth.
The formula for calculating the accounts receivable turnover ratio divides the net credit sales by the average accounts receivable for the corresponding periods.
Accounts Receivable Turnover = Net Credit Sales ÷ Average Accounts ReceivableNet credit sales are calculated as the total credit sales adjusted for any returns or allowances.
The average accounts receivable is equal to the beginning and end of period A/R divided by two.
The portion of A/R determined to no longer be collectible – i.e. “bad debt” – is left unfulfilled and is a monetary loss incurred by the company.
Generally, the higher the accounts receivable turnover ratio, the more efficient a company is at collecting cash payments for purchases made on credit.
Companies with efficient collection processes possess higher accounts receivable turnover ratios.
The accounts receivables turnover metric is most practical when compared to a company’s nearest competitors in order to determine if the company is on par with the industry average or not.
If the accounts receivable turnover is low, then the company’s collection processes likely need adjustments in order to fix delayed payment issues.
Low A/R turnover stems from inefficient collection methods, such as lenient credit policies and the absence of strict reviews of the creditworthiness of customers.
We’ll now move to a modeling exercise, which you can access by filling out the form below.
For our illustrative example, let’s say that you own a company with the following financials.
Financial Data (Year 1)
Financial Data (Year 2)
Since sales returns and sales allowances are outflows of cash, both are subtracted from total credit sales.
The net credit sales come out to $100,000 and $108,000 in Year 1 and Year 2, respectively.
The next step is to calculate the average accounts receivable, which is $22,500.
Now for the final step, the net credit sales can be divided by the average accounts receivable to determine your company’s accounts receivable turnover.
Given the accounts receivable turnover ratio of 4.8x, the takeaway is that your company is collecting its receivables approximately five times per year.
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