The accounts receivable (AR) turnover ratio is a financial measure that shows how efficiently a company collects payments from its credit sales. This ratio is computed by dividing net sales by the average accounts receivable. A higher ratio is typically favorable, as it indicates that the company is able to collect its receivables more swiftly. Net sales are derived from total credit sales minus sales returns and allowances.
Many companies extend short-term credit facilities to their customers and collect the payment for such credit sales after a few days or weeks. However, some companies are more efficient at collecting these debts than others. The receivables turnover ratio, also known as the debtors’ turnover ratio, helps measure this efficiency.
So, what is the receivables turnover ratio? In simple terms, it is the frequency at which a company collects its accounts receivables from its customers. The more frequent these debt collections are, the more efficient a company is at converting its credit sales into cash flows.
In this article, we take a deep dive into the meaning of the receivables turnover ratio, its formula and calculation, the benefits of tracking this ratio and more.
What is Receivables Turnover Ratio?
The receivables turnover ratio assesses how effectively a company collects payments on the credit extended to its customers. It also indicates the number of times a company's receivables are converted into cash within a specific period. This ratio can be calculated on an annual, quarterly, or monthly basis.
Companies regularly conduct sales on a credit basis. This essentially means that even though the product or service is delivered to the customer, they need not pay for the purchase right away. Instead, the selling company gives the customer a definite period within which they can make the payment—say 10 days or 30 days.
This kind of credit is recorded in the company’s books as accounts receivables. When the said credit period expires, the company needs to collect these debts from the customers.
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Formula of Receivables turnover ratio
Mathematically, the receivables turnover ratio compares the net credit sales completed by a company with its average accounts receivables. So, here is the receivables turnover ratio formula:
Receivables turnover ratio = Net credit sales ÷ Average accounts receivable
Here, the net credit sales in the numerator of the ratio is the net amount a company earns from its credit sales. This does not include sales that are settled in cash and cash equivalents. Keep in mind that this is not the same as the gross credit sales as it factors in any returns from customers and discounts offered to them.
The denominator of the receivables turnover ratio formula is the average accounts receivable. This is essentially the average of the accounts receivable balance at the start and the end of the period being considered. Since the receivables turnover ratio can be computed on a monthly, quarterly or annual basis, the average accounts receivable needs to be calculated accordingly.
How to calculate Receivables Turnover Ratio?
To calculate the receivables turnover ratio, you need to follow the steps outlined below.
Step 1: Identify the period for receivables turnover ratio calculation
Begin by identifying the period over which you want to find the ratio. You can calculate this indicator for one month, one quarter or even one year.
Step 2: Determine the net credit sales
For the period concerned, determine the net sales made via credit. You can find this information in the company’s income statement.
Step 3: Find the average accounts receivable
The next step is to find the average accounts receivable. You can calculate this using the following formula:
Average accounts receivable = 1/2 x (Accounts receivable at the beginning of the period — Account receivable at the end of the period)
Step 4: Use the receivables turnover ratio formula
Then, you need to simply use the receivables turnover ratio formula to find the ratio. This involves dividing the net credit sales by the average accounts receivable.
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Example of Receivables turnover ratio calculation
Let us discuss a small example to understand how the receivables turnover ratio calculation works. Consider the following data from a company’s financial statements for one month.
- Total credit sales = Rs. 5,40,000
- Total returns = Rs. 40,000
- Accounts receivable at the start of the month = Rs. 50,000
- Accounts receivable at the end of the month = Rs. 70,000
Based on this information, we find that the net credit sales amount to Rs. 5,00,000 (i.e. Rs. 5,40,000 - Rs. 40,000) and the average accounts receivable amounts to Rs. 60,000 (i.e. the average of Rs. 50,000 and Rs. 70,000).
So, the receivables turnover ratio is 8.33 (i.e. Rs. 5,00,000 ÷ Rs. 60,000). This essentially means that the company collected its accounts receivables 8.33 times during the month.
Importance of receivables turnover ratio
The receivables turnover ratio provides valuable insights into a company's financial health and operational efficiency. Here’s what the ratio can reveal about a company:
- Efficiency in collecting credit sales: The ratio indicates how effectively a company is collecting payments on its credit sales. A faster turnover means the company can access capital quickly, improving liquidity for day-to-day operations and future growth.
- Collateral opportunities for borrowing: Some lenders may accept accounts receivable as collateral for loans. A strong receivables turnover ratio can enhance a company’s ability to leverage its receivables to secure financing, particularly from banks and financial institutions.
- Capacity for large capital investments: By understanding how swiftly receivables are converted into cash, a company can predict its future cash flow more accurately. This helps in planning for significant investments, such as purchasing assets or expanding operations, which is crucial for businesses operating in India’s fast-evolving markets.
- Assessment of credit risk: A low receivables turnover ratio may suggest that a company is not thoroughly assessing the creditworthiness of its clients. In the Indian market, where payment delays and defaults can be common, a poor ratio could signal higher credit risk, possibly leading to client insolvency and financial losses.
- Long-term performance trends: Analysing the receivables turnover ratio over time helps a company track its performance and identify trends. This is particularly useful for businesses in India that need to adjust to seasonal fluctuations or economic cycles affecting payment behaviours.
- Comparison with competitors: The ratio also allows a company to benchmark itself against industry peers. By comparing the receivables turnover ratios of similar companies, a business can assess whether it is leading in its sector or lagging behind, helping to refine strategies for competitive advantage in India’s diverse financial landscape.
What does a high receivables turnover ratio mean?
A high receivables turnover ratio could mean many things. For starters, it could indicate that the company is highly efficient at collecting its accounts receivables from credit purchasers. It may also be that most of the company’s customers settle their credit buys within the due date, so the company’s cash flow is not compromised.
A company may also have a high receivables turnover ratio because it may be more conservative about the customers to whom credit sales are offered. If credit sales are only conducted with customers who have a good track record and credit history, the chances of default are fairly low. Alternatively, a high debtors’ turnover ratio could also mean that a company predominantly carries out cash sales.
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What does a low receivables turnover ratio mean?
A low receivables turnover ratio is never a good sign. It mainly stems from the issue of poor collection policies. A company may not have effective accounts receivables collection strategies in place. Alternatively, it may also be a sign that the company’s customers are mostly not creditworthy. This may lead to undue delays in paying the dues, causing a low receivables turnover ratio.
Sometimes, the reason for the low debtors’ turnover ratio may be due to poor distribution channels too. If customers do not receive their products within the time specified, their payments may also be correspondingly delayed. Either way, a low receivables turnover ratio is a sign that the company needs to look into its credit sales policies and make the necessary changes to improve the process of extending credit and collecting the payments due.
Benefits of tracking receivables turnover ratio
The receivables turnover ratio can give you many insights into a company’s operational efficiency. Here are some of the top reasons to check this ratio before you decide whether a company may be worth investing in.
- Cash flow management: The ratio indicates how efficiently a company collects its accounts receivables. A high value suggests more efficient collection, which improves cash flow.
- Operational efficiency: The receivables turnover ratio also reflects a company’s operational efficiency and how well it manages its credit sales.
- Financial health: The indicator also offers insights into the overall financial health of a company. A declining receivables turnover ratio may point to potential liquidity issues.
- Comparative analysis: You can also use this ratio to benchmark a company against its industry standards to see where it stands relative to its peers and competitors.
What is a good accounts receivable turnover ratio?
There is no single benchmark number that separates a good receivables turnover ratio from a poor one. The assessment depends on the industry in which the company operates. In some industries, longer credit periods may be the norm. So, to assess if a company’s receivables turnover ratio is low or high, you need to compare it with its industry average and with its historical ratio values.
Similarly, the company’s size and growth stage may also affect its credit sales and credit periods. Established entities may offer more lenient credit periods than growing companies that require quick turnovers.
Ways to improve the accounts receivable turnover ratio
Improving the AR turnover ratio is crucial for businesses because it eases their cash flows. Here are some effective strategies to ensure this ratio increases.
1. Ensure accurate and regular invoicing
To ensure that your customers pay you promptly, you need to send your invoices on time and regularly. Your invoice should also be accurate, so customers can get a clear idea of the amount they owe.
2. Set clear terms for payment
Ambiguous payment terms may lead to further delays and bring your receivables turnover ratio down. To avoid this, set out clear guidelines regarding the amount due, the date by which it is due and the modes of payment you accept.
3. Offer multiple payment options
Limiting the payment options for customers can make the process more challenging for them. This, in turn, could cause delays in settlement. To work around this issue, you can offer different payment options like debit cards, credit cards, UPI, cheques and bank transfers.
4. Levy a fee for late payment
If you have customers with a poor credit history, levying an extra fee for late payment may help. The incentive to avoid additional charges can be a great motivator to ensure that your customers pay for their credit purchases promptly.
5. Send regular reminders to buyers
Some customers may forget that the due date is approaching. By sending regular reminders to your buyers, you can ensure that they remember to budget for your credit sale and pay the dues promptly.
6. Offer discounts if it is feasible
Discounts for early payments can encourage your customers to settle their dues faster. If your finances have room for such discounts, consider offering them to customers who have purchased products or services on credit.
7. Build better relationships with your customers
When you build stronger relationships with your customers, they automatically develop a sense of responsibility to repay their dues to your company within the due date. Happy customers are typically loyal customers too.
8. Make cash sales more attractive
If you are having trouble closing the credit sales cycle, consider switching to cash sales by making them more attractive to customers. Offer incentives or discounts for cash purchases so you can skip the collection process entirely.
9. Leverage automation
Automating the collection process can help save significant time and effort. If you cannot reduce or replace your credit sales with cash sales, consider using automation to your advantage.
Limitations of the accounts receivable ratio
The receivables turnover ratio is generally a reliable measure of a company’s efficiency in collecting its debts. However, it has certain limitations, as outlined below.
- Inflated ratios: Some companies use the total sales instead of the net sales to calculate this ratio. This skews the ratio and makes it higher than its actual value. So, if you are using a ratio already calculated by the company, ensure you know which figures were used.
- Highly variable: The receivables turnover ratio varies greatly during the year. During some months, the collection may be quick, while during others, the process may take time. This is particularly seen in companies with seasonal sales.
- Potentially misleading results: When the ratio is calculated over a longer period, like 12 months, it may potentially be misleading. This is because it does not accurately reflect the true efficiency of the collection process.
Key takeaways
- The accounts receivables turnover ratio measures the efficiency of a company’s debt collection process.
- To calculate this ratio, you divide the net credit sales carried out during a period by the average accounts receivable during that period.
- The higher the ratio, the better because it indicates that the company is efficient at collecting the payments due on its credit sales.
- To improve the receivables turnover ratio, companies can adopt measures like offering discounts for early payments, charging a late fee, building stronger customer relationships and offering different payment options.
Conclusion
The accounts receivables turnover ratio is only one of the many financial indicators you need to factor in before you decide whether a company makes a suitable investment. For the average retail investor with limited time and experience, considering all the necessary factors may be challenging.
An easier alternative is investing in mutual funds on the Bajaj Finserv Mutual Fund Platform. With over 1,000 mutual fund schemes available to choose from, this platform makes it easy to compare mutual funds, factor in various ratios and choose funds that invest in financially strong companies. You can even use the mutual fund calculator on this platform to make smarter investment decisions.
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