# Receivables Turnover Ratio

The accounts receivables turnover ratio help to understand how often a company gathers its average accounts receivable balance.
Receivables Turnover Ratio
3 min
23-July-2024
The Accounts Receivable Turnover Ratio assesses the efficiency with which a company converts its accounts receivable into cash during a specific accounting period. This ratio is computed by dividing net sales by the average accounts receivable. 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?

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. The receivables turnover ratio, also known as the accounts receivables turnover ratio, measures the effectiveness of collecting these debts.

## 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.

## 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.

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## 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.

## 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.

## Reasons to track the 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.

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## Frequently asked questions

What is a good receivables turnover ratio?
The answer to this is subjective and depends on the industry in which a company operates. However, as a general rule of thumb, the higher the receivables turnover ratio, the better.

What is the meaning of the receivables turnover?
The receivables turnover or debtors’ turnover means the number of times a company collects its accounts receivable from its customers.

What is another term for the receivables turnover ratio?
Another term for the receivables turnover ratio is the debtors’ turnover ratio. This is because it involves collecting revenue due from debtors who have benefited from credit sales.

How can you improve the accounts receivable turnover?
To improve the accounts receivables turnover, companies can streamline invoice generation, build better relationships with customers, send reminders to buyers or even charge a late fee.

What does an accounts receivable turnover ratio of 12 mean?
If the accounts receivables turnover ratio of a company is 12 for a given period, it means the company collected its debts from credit buyers 12 times during the period.

What is a high receivables turnover ratio?
A high receivables turnover ratio indicates that the company collects its accounts receivables efficiently. The answer to what makes a ratio high is subjective and depends on the company’s history and the industry average.

What is an example of an accounts receivable turnover ratio?
Let’s say that a company has net credit sales amounting to Rs. 10 lakhs during a year. Its average accounts receivable during the year comes out to be Rs. 1.5 lakhs. So, the debtors’ turnover ratio for this year will be 6.67 (i.e. Rs. 10 lakhs ÷ Rs. 1.5 lakhs).

Is 12 a good accounts receivable turnover ratio?
Yes, an accounts receivables turnover ratio of 12 can be considered a good number, depending on the industry average. It means that the company collects its debts 12 times during the year or period concerned.

What does a low AR turnover ratio mean?
A low AR turnover ratio means that the company is inefficient at collecting its accounts receivables within the time they are due.

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