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Accounts Receivable Turnover Ratio

What Is the Accounts Receivable Turnover Ratio?

The accounts receivable turnover ratio is a figure that is calculated to measure how effectively the business converts outstanding debt from customers into completed payments.

Accounts receivable refers to outstanding short-term debt or payments.

The turnover ratio represents the average value of accounts receivable for an accounting period in proportion to the total number of credit sales for the same period.

A high accounts receivable turnover ratio is a positive sign for the business, while a low ratio is a poor sign. A high turnover ratio indicates that the business has a high percentage of customers who are converting their outstanding debt into payments.

That is, they are paying their bills in a timely manner. This indicates that the business is doing a good job collecting payments from customers. Conversely, a low turnover ratio reveals that the business is doing a poor job of collecting payments.

How Is the Accounts Receivable Turnover Ratio Calculated?

There are two steps to calculate the accounts receivable turnover ratio, which is calculated as a fraction.

  1. Add the balance for accounts receivable at the beginning of the reporting period to the balance at the end and divide by 2. This produces the average value of accounts receivable for the period.

  2. Create the fraction (ratio). The calculation starts with the total value of sales on credit for the accounting period (cash sales are completed at the time of the transaction; they do not generate outstanding payments/accounts receivable and are not included in this total). This figure is divided by the average value of accounts receivable that was calculated in the first step.  

Because the credit sales figure is the nominator in this equation, a larger average figure for accounts receivable will generate a lower fraction or ratio. If the average accounts receivable denominator is a small figure, it will generate a larger number.

Remember also that a larger number is a good sign for the business, while a smaller number is a bad sign. This is because a high turnover ratio means the business is converting a higher proportion of its credit sales into cash, and a lower turnover ratio means it is converting a smaller percentage of its credit sales into cash.

FAQ

Why Is the Accounts Receivable Turnover Ratio Important?

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.

What Are Some Examples of Accounts Receivable Turnover Ratio?

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.

What Is Considered a Good Accounts Receivable Turnover Ratio?

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.

What Is the Accounts Receivable Turnover Ratio in Days?

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.

Accounts Receivable Automation Software with BlackLine

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