Accounts Receivable Turnover Ratio

The accounts receivable turnover ratio is a very important measure for the business because it indicates how effectively the business is converting its outstanding payments into cash revenue.

Businesses extend credit to customers to build trust and goodwill, and to expand their customer base. However, if too many customers are not paying their bills, the business is either doing a poor job of collecting those payments, or it may have overextended its goodwill.

In other words, it may have extended too much credit or credit to too many unreliable customers. In either case, the business will not be able to convert enough outstanding transactions into cash and it will not have enough revenue to support its operating needs.

This is a sign that the business is not performing well.

When a business has a high turnover ratio, this indicates its effectiveness in converting credit sales to cash. It means that the business has a reliable customer base who pay their bills on time. It may also indicate that the business has a more effective process for collecting payments on credit purchases.

Additionally, it might indicate that the business conducts more sales on cash than credit.

Not all indicators in this scenario are positive. A high turnover ratio may also indicate that the business is being too cautious in extending credit. This could result in losing some customers to other business that are more generous with credit.

A good way to understand how the accounts receivable turnover ratio works is to look at some examples.

If a business has $1,000 worth of credit sales and an average value of accounts receivable for the accounting period of $500, the accounts receivable turnover ratio will equal 2 ($1000 ÷ $500 = 2).

This means that the business is converting credit sales to cash two times during the accounting period.

If another business has $1,000 worth of credit sales and an average value of accounts receivable of $100, the accounts receivable turnover ratio will equal 10 ($1000 ÷ $100 = 10).

This means that the business is converting credit sales 10 times during the accounting period.

The average value of the accounts receivable was larger—and closer in value to the total value of credit sales—in the first example. This produced a lower number for the accounts receivable turnover ratio (a quotient that is closer to 1), which is an indication that the business is performing poorly.

In the second example, the average value of accounts receivable was much smaller in proportion to the total value of credit sales, which produced a higher ratio, indicating that the business is doing a better job of converting sales to cash.

A higher turnover ratio is considered a good sign for the business.

However, the value of the accounts receivable turnover ratio is generally determined by comparing to other similar businesses. For example, if a business has a ratio of ten and the average rate for its competitors is five, then they have a much better turnover ratio than the industry average.

For further analysis, accountants may use the accounts receivable turnover ratio to calculate another ratio.

The accounts receivable turnover ratio in days reveals how many days it takes to collect payments.

It is calculated by dividing the number of days in the accounting period by the turnover ratio.

In the second example above, if the accounting period under review was for one month, the accounts receivable turnover ratio in days would be calculated by dividing the number of days in the month, 30, by the turnover ratio, 10. The turnover ratio in days would be 3 (30 ÷ 10 = 3).

This means that it takes three days on average for the business to collect payment on its credit sales.

Request a demo and we'll show you exactly how our accounts receivable automation software can help you maximize working capital in a unified platform for collecting cash, providing credit, and understanding cash flow.