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If you’re ready to say goodbye to those red and barely “in the black” income statements, it’s time to take your business to the next level by learning to calculate, track, and interpret one of the most important financial ratios: your accounts receivable turnover ratio. From there, you’ll be ready to make strategic decisions that will take your business in a healthier, more profitable direction.
In this guide, we’ll break down everything you need to know about what a receivables turnover ratio is, how to calculate it, and how you can use it to improve your business.
What is the receivables turnover ratio?
Most businesses operate on credit, which means they deliver the goods or services upfront, invoice the customer, and give them a set amount of time to pay. Businesses use an account in their books known as “accounts receivable” to keep track of all the money their customers owe.
Since you can never be 100% sure when payment will come in for goods or services provided on credit, managing your own business’s cash flow can be tricky. That’s where an efficiency ratio like the accounts receivable turnover ratio comes in.
The accounts receivable turnover ratio, also known as receivables turnover, is a simple formula that calculates how quickly your customers or clients pay you the money they owe. It also serves as an indication of how effective your credit policies and collection processes are.
By monitoring this ratio from one accounting period to the next, you can predict how much working capital you’ll have on hand and protect your business from bad debt.
Your receivables turnover ratio can also help you determine the impact of credit practices on profitability, identify when you need to make updates on ineffective and collection processes, secure loans and investors, and plan strategically for the future.
Did you know? Businesses that complete most of their purchases by extending credit to customers tend to use accrual accounting, as it accounts for earned income that has not yet been paid. Cash basis accounting, on the other hand, simply tracks money when it’s actually paid or spent on expenses.
Formula and calculation of receivables turnover ratio
If accounting and finance weren’t your forte in school and you’ve never seen this ratio before, don’t panic. The accounts receivable turnover ratio formula isn’t complex. You’ve got this!
Step 1: Identify your net credit sales
Net credit sales refers to the revenue you earn from sales made on credit after subtracting any returns and allowances. The formula for net credit sales looks like this:
Net credit sales = Annual credit sales - (Sales returns + Sales allowances)
You can find the numbers you need to plug into the formula on your annual income statement or balance sheet.
Step 2: Determine average accounts receivable
Average accounts receivable is used to calculate the average amount of your outstanding invoices paid over a specific period of time.
We calculate the average accounts receivable by dividing the sum of a specific timeframe’s beginning and ending receivables (most frequently months or quarters) and dividing by two.
Step 3: Calculate your accounts receivable turnover ratio
To determine your receivables turnover ratio, you simply divide your net credit sales (from step 1) by your average accounts receivable (from step 2). The accounts receivable turnover ratio formula looks like this:
Accounts receivable turnover ratio = (Net credit sales) / (Average accounts receivable)
Use this formula to calculate the receivables turnover ratio for your business at least once every quarter. Track and compare these results to identify any trends or patterns that may develop.
Still confused? See our examples section below for a comprehensive example that applies this step-by-step process.
What does the receivables turnover ratio tell you?
Once you have calculated your company’s accounts receivable turnover ratio, it’s nearly time to use it to improve your business. But first, you need to understand what the number you calculated tells you.
Collection time
Using your receivables turnover ratio, you can determine the average number of days it takes for your clients or customers to pay their invoices. This is also known as your average collection period.
To identify your average collection period, divide the number of days in your accounting cycle by the receivables turnover ratio.
For example, if your receivables turnover ratio for the year is 32, that means over the fiscal year, your business collected on its outstanding invoices 32 times. In this case, you divide the number of days in a year (365) by your receivables turnover ratio (32).
365 / 32 = 11.5 days
Therefore, it takes this business’s customers an average of 11.5 days to pay their bills. In most industries, that’s a high-quality customer base.
You can use this average collection period information to compare your company’s receivables turnover time with that of other companies in your industry.
Industry matters
For the most part, there are two types of ratio results—high and low. Of course, you’ll want to keep in mind that “high” and “low” are determined by industry norms. For example, giving clients 90 days to pay an invoice isn’t abnormal in construction but may be considered high in other industries.
With 90-day terms, you can expect construction companies to have lower ratio numbers. If you’re in construction, you’ll want to research your industry’s average receivables turnover ratio and compare your company’s ratio based on those averages.
Cleaning companies, on the other hand, typically require customer payment within two weeks. If you own one of these businesses, your idea of “high” or “low” ratios will be vastly different from that of the construction business owner.
High receivables turnover ratios
A high turnover ratio has many potential meanings. It most often means that your business is very efficient at collecting the money it’s owed. That’s also usually coupled with the fact that you have quality customers who pay on time. These on-time payments are significant because they improve your business’s cash flow and open up credit lines for customers to make additional purchases.
Another reason you may have a high receivables turnover is that you have strict or conservative credit policies, meaning you’re careful about who you offer credit to. When you have specific restrictions for those you offer credit to, it helps you avoid customers who aren’t credit-worthy and are more likely to put off paying their debts.
Of course, it’s still wise to make sure you’re not too conservative with your credit policies, as too restrictive policies lead to loss of clients and slow business growth.
With certain types of business, such as any that operate primarily with cash sales, high receivables turnover ratio may not necessarily point to business health. You may simply end up with a high ratio because the small percentage of your customers you extend credit to are good at paying on time.
Even if you trust the businesses that you extend credit to, there are other reasons you may want to make a more serious effort to develop a higher ratio.
For example, the accounts receivable turnover ratio is one of the metrics that business investors and lenders look at when determining whether to invest in or loan money to your business. Investors and lenders want to see receivables turnover ratios similar or slightly higher than other businesses in your industry.
Low receivables turnover ratios
A low accounts receivable turnover ratio, on the other hand, often indicates that the credit policies of the business are too loose. For example, you may allow a longer period of time for clients to pay or not enforce late fees once your deadline to pay has passed.
Credit policies that are too liberal frequently bring in too many businesses that are unstable and lack creditworthiness. This can be dangerous for the health of your own business. If you never know if or when you’re going to get paid for your work, it can create serious cash flow problems.
As a small business, cash flow issues can add up fast. When your customers don’t pay on time, it can lead to late payments on your own bills. Unpaid invoices can negatively affect the end-of-year revenue statements and scare away potential lenders and investors.
Liberal credit policies may initially be attractive because they seem like they’ll help establish goodwill and attract new customers. Although that may be true, nothing negates positive feelings like having to hassle someone over unpaid bills.
Additionally, with credit policies that are too liberal, you’re more likely to have customers who default or file for bankruptcy; when that happens, your only consolation is getting to write it off as a loss on your business’s taxes. As a rule of thumb, sticking with more conservative policies will typically shorten the time you have to wait for invoiced payments and save you from loads of cash flow and investor problems later on.
A low ratio may also indicate that your business has subpar collection processes. On the other hand, it could also be that your collection staff members are not receiving the training they need or are not assertive enough when following up on unpaid invoices.
Learn more:
Example of accounts receivable turnover ratio
Now that you understand what an accounts receivable turnover ratio is and how to calculate it, let’s take a look at an example.
In this section, we’ll look at Alpha Lumber’s (fictional) financial data to calculate its accounts receivable turnover ratio. Then, we’ll discuss what the company’s ratio says about its current status and identify areas for improvement.
Alpha Lumber
Net credit sales: $400,000
Determine net credit sales
Since we already have our net credit sales ($400,000), we can skip straight to the second step—identifying the average accounts receivable.
Identify average accounts receivable
As we previously noted, average accounts receivable is equal to the first plus the last month (or quarter) of the time period you’re focused on, divided by 2.
Average accounts receivable = (First period + Last period) / 2
Let’s plug Alpha Lumber’s data into the formula.
We start by replacing the company’s “first period” of receivables with the January 1 data and “last period” with the information for December 31. Then we add them together and divide by two, giving us $35,000 as the average accounts receivable.
($30,000 + $40,000) / 2 = $35,000
Calculate receivables turnover ratio
Now that we know that the average accounts receivable is $35,000, we can plug that number into the formula for the accounts receivable turnover ratio.
Here’s our formula again:
Accounts receivable turnover ratio = (Net credit sales) / (Average accounts receivable)
So, for Alpha Lumber:
Accounts receivable ratio = $400,000 / $35,000 = 11.43
To determine the average number of days it took to get invoices paid, you must divide the number of days per year, 365, by the accounts receivable turnover ratio of 11.4.
Average collection period = 365 / 11.43 = 49.3 days
Interpreting Alpha Lumber’s ratio
The receivables turnover ratio shows us that Alpha Lumber collected its receivables 11.43 times during 2021. In other words, Alpha Lumber converted its receivables (invoices for credit purchases) to cash 11.43 times during 2021.
Since industries can differ from each other rather significantly, Alpha Lumber should only compare itself to other lumber companies.
Assuming that this ratio is low for the lumber industry, Alpha Lumber’s leaders should review the company’s credit policies and consider if it’s time to implement more conservative payment requirements. This might include shortening payment terms or even adding fees for late payments.
Alpha Lumber should also take a look at its collection staff and procedures. The business may have a low ratio as a result of staff members who don’t fully understand their job description or may be underperforming. If clients have mentioned struggling with or disliking your payment system, it may be time to add another payment option.
If Alpha Lumber’s turnover ratio is high, it may be cause for celebration, but don’t stop there. Company leadership should still take the time to reevaluate current credit policies and collection processes. Then, they should identify and discuss any additional adjustments to those areas that may help the business receive invoice payments even more quickly (without pushing customers away, of course).
Regardless of whether the ratio is high or low, it’s important to compare it to turnover ratios from previous years. Doing so allows you to determine whether the current turnover ratio represents progress or is a red flag signaling the need for change.
How Bench can help
Your business’s long-term strategy relies on accurate financial records. With Bench at your side, you’ll have the meticulous books, financial statements, and data you’ll need to play the long game with your business. It’s easy to make that data work for you.
Monthly income statements can help you budget and boost profitability, while up-to-date expense reports allow you to spot spending trends and better control cash flow. Maximize revenue, know your strengths, and plot a course for success: bookkeeping and reporting with Bench is everything you need to gain the upper hand. Bookkeeping works better with Bench.
Limitations of the receivables turnover ratio
While the receivables turnover ratio can be handy, it has its limitations like any other measurement.
For example, while the ratio may be able to identify that it takes your company longer to receive payment than most in your industry, it can’t point to the specific cause or causes for the low ratio, such as problem client or underperforming collections staff. You have to do the legwork to figure all that out.
The receivables turnover ratio is also an average. And as an average, it has the potential to be skewed by even one or two outliers, such as clients who pay their invoice the day it’s issued or the one client who is always asking for more time and paid their last invoice 10 months after you sent it.
There’s no ideal ratio that applies to every business in every industry. Norms that exist for receivables turnover ratios are industry-based, and any business you want to compare should have a similar structure to your own.
Lastly, many business owners use only the first and last month of the year to determine their receivables turnover ratio. However, the time it takes to receive payments often varies from quarter to quarter, especially for seasonal companies. As a result, you should also consider the age of your accounts receivable to determine if your ratio appropriately reflects your customer payment.
Use the receivables turnover ratio to take action
Your business’s receivables turnover ratio measures how effectively your company collects on sales made on credit.
Higher turnover ratios imply healthy credit policies, strong collection processes, and relatively prompt customer payments. You’re also likely not to encounter many obstacles when searching for investors or lenders. Lower turnover ratios indicate that your business collects on its invoices inefficiently and is cause for concern.
When you know where your business stands, you can invest your time in solving the problem—or getting even better.
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