What Is the Receivables Turnover Ratio?
The term receivables turnover ratio refers to an accounting measure that quantifies a company's effectiveness in collecting its accounts receivable. This ratio measures how well a company uses and manages the credit it extends to customers and how quickly that short-term debt is collected or is paid. An efficient has a higher accounts receivable turnover ratio while an inefficient company has a lower ratio. This metric is commonly used to compare companies within the same industry to gauge whether they are on par with their competitors.
- The accounts receivable turnover ratio is an accounting measure used to quantify how efficiently a company is in collecting receivables from its clients.
- The ratio also measures the times that receivables are converted to cash during a certain time period.
- A high ratio may indicate that corporate collection practices are efficient with quality customers who pay their debts quickly.
- A low ratio could be the result of inefficient collection processes, inadequate credit policies, or customers who are not financially viable or creditworthy.
- Investors should be mindful that some companies use total sales rather than net sales to calculate their ratios, which may inflate the results.
Receivables Turnover Ratio
Understanding Receivables Turnover Ratios
Accounts receivable are effectively interest-free loans that are short-term in nature and are extended by companies to their customers. If a company generates a sale to a client, it could extend terms of 30 or 60 days, meaning the client has 30 to 60 days to pay for the product. The ability to collect on these debts depends on a number of factors, including financial and economic conditions and, more importantly, the client.
The receivables turnover ratio measures the efficiency with which a company is able to collect on its receivables or the credit it extends to customers. The ratio also measures how many times a company's receivables are converted to cash in a certain period of time. The receivables turnover ratio is calculated on an annual, quarterly, or monthly basis.
A company’s receivables turnover ratio should be monitored and tracked to determine if a trend or pattern is developing over time. Companies can also track and correlate the collection of receivables to earnings to measure the impact the company’s credit practices have on profitability.
For investors, it's important to compare the accounts receivable turnover of multiple companies within the same industry to get a sense of the normal or average turnover ratio for that sector. If one company has a much higher receivables turnover ratio than the other, it may be a safer investment. We look at what both high and low turnover ratios mean a little further below.
Accounts receivables appear under the current assets section of a company's balance sheet.
Formula and Calculation of the Receivables Turnover Ratio
Accounts Receivable Turnover Ratio = Net Credit Sales / Average Accounts Receivable
As noted above, it's always a good idea to compare the receivables turnover ratios of companies that operate within the same industry. So it doesn't make sense to compare the ratio of a small utility company with that of a large oil and gas corporation. That's because there are a number of different factors at play, such as lending terms and the sheer quality of customers who owe money.
When making comparisons, it's ideal to look at businesses that have similar business models. Once again, the results can be skewed if there are glaring differences between the companies being compared. That's because companies of different sizes often have very different capital structures, which can greatly influence turnover calculations, and the same is often true of companies in different industries.
High vs. Low Receivables Turnover Ratio
A high receivables turnover ratio can indicate that a company’s collection of accounts receivable is efficient and that it has a high proportion of quality customers who pay their debts quickly. A high receivables turnover ratio might also indicate that a company operates on a cash basis.
A high ratio can also suggest that a company is conservative when it comes to extending credit to its customers. Conservative credit policies can be beneficial since they may help companies avoid extending credit to customers who may not be able to pay on time.
On the other hand, having too conservative a credit policy may drive away potential customers. These customers may then do business with competitors who can offer and extend them the credit they need. If a company loses clients or suffers slow growth, it may be better off loosening its credit policy to improve sales, even though it might lead to a lower accounts receivable turnover ratio.
A low receivables turnover ratio isn't a good thing. That's because it may be due to an inadequate collection process, bad credit policies, or customers that are not financially viable or creditworthy. A low turnover ratio typically implies that the company should reassess its credit policies to ensure the timely collection of its receivables. However, if a company with a low ratio improves its collection process, it might lead to an influx of cash from collecting on old credit or receivables.
In some cases, though, low ratios aren't always bad. For example, if the company's distribution division is operating poorly, it might be failing to deliver the correct goods to customers in a timely manner. As a result, customers might delay paying their receivables, which would decrease the company’s receivables turnover ratio.
The asset turnover ratio is another important metric. It measures the value of a company's sales or revenues relative to the value of its assets and indicates how efficiently a company uses its assets to generate revenue. A higher ratio means the company is more efficient. A low asset turnover ratio indicates that the company is using its assets inefficiently to generate sales.
Limitations of the Receivables Turnover Ratio
The receivables turnover ratio is just like any other metric that tries to gauge the efficiency of a business in that it comes with certain limitations that are important for any investor to consider.
For example, some companies use total sales instead of net sales when calculating their turnover ratio. This can actually inflate the results. While this is not always meant to deliberately mislead investors, they should ascertain how a company calculates its ratio. Another option would be to calculate it themselves independently.
Another limitation is that AR varies dramatically throughout the year. This is often the case with seasonal companies. These entities likely have periods with high receivables along with a low turnover ratio and periods when the receivables are fewer and can be more easily managed and collected.
In other words, the ratio may not reflect the company's effectiveness of issuing and collecting credit if an investor chooses a starting and endpoint for calculating the ratio arbitrarily. As such, the beginning and ending values selected when calculating the average accounts receivable should be carefully chosen to accurately reflect the company's performance. Investors could take an average of accounts receivable from each month during a 12-month period to help smooth out any seasonal gaps.
Example of Receivables Turnover Ratio
Let's say Company A had the following financial results for the year:
- Net credit sales of $800,000.
- $64,000 in accounts receivables on Jan. 1 or the beginning of the year.
- $72,000 in accounts receivables on Dec. 31 or at the end of the year.
We can calculate the receivables turnover ratio in the following way:
ACR=2$64,000+$72,000=$68,000ARTR=$68,000$800,000=11.76where:ACR = Average accounts receivableARTR = Accounts receivable turnover ratio
We can interpret the ratio to mean that Company A collected its receivables 11.76 times on average that year. In other words, the company converted its receivables to cash 11.76 times that year. A company could compare several years to ascertain whether 11.76 is an improvement or an indication of a slower collection process.
A company could also determine the average duration of accounts receivable or the number of days it takes to collect them during the year. In our example above, we would divide 365 by 11.76 to arrive at the average duration. The average accounts receivable turnover in days would be 365 / 11.76, which is 31.04 days.
For Company A, customers on average take 31 days to pay their receivables. If the company had a 30-day payment policy for its customers, the average accounts receivable turnover shows that, on average, customers are paying one day late.
A company could improve its turnover ratio by making changes to its collection process. A company could also offer its customers discounts for paying early. Companies need to know their receivables turnover since it is directly tied to how much cash they have available to pay their short-term liabilities.