Account receivable turnover ratio is a measure to indicate how quickly a company collects its receivables (credit sales) into cash that can be used in business. The account receivable turnover can measure how well an organization is managing its account receivable.
The account receivable turnover is calculated by dividing the net sales revenue by the average accounts receive able. It is a measure of how many times old receivables are collected and replaced by new receivables.
Financial managers and executives use the account receivable turnover ratio as a way to monitor and measure cash flow and how well companies manage uses and manage the credit they provide to their customers by estimating how long it takes them to pay down outstanding debt in a year.
What Does the Account Receivable Turnover Measure
Analysis can measure liquidity by how quickly a company converts certain assets to cash. Low values of the previous ratios can sometimes be compensated for if some of the company’s current assets are highly liquid.
A higher account receivable turnover rate means the business is running efficiently. A high turnover ratio is desirable because it suggests that the company’s debt collection process is efficient, that the company has a quality customer base, or that the company has a conservative credit policy.
Conversely, a low account receivable turnover ratio indicates that the company may have a bad credit policy, a bad debt collection method, or that its customers are unreliable or financially unviable. The low turnover is likely due to weak credit policies, inadequate collection process and/or a client base in financial distress.
Account Receivable Turnover Formula
The account receivable turnover can be calculated by dividing the net sales revenue by the average accounts receive able, or the following formula:
ART ratio = Net sales revenue ÷ Average accounts receivable
- Net sales = Gross sales – Returns – Allowances – Discounts
- Average accounts receivable is calculated by dividing the sum of beginning and ending accounts receivable by 2.
The reason for using net sales on credit rather than net sales is that cash sales do not generate credit. Only credit sales create credit, so cash sales are not counted. However, some companies may use total sales as the numerator rather than net credit sales.
Let’s say the Feriors company had the following financial results for last year:
- Net credit sales of $100,000.
- $10,000 in accounts receivables at the beginning of the year.
- $15,000 in accounts receivables at the end of the year.
Average account receivable = (10,000 + 15,000) ÷ 2 = 12,500
Account receivable turnover = 100,000 ÷ 12,500 = 8 times in a year.
Average Collection Period
Additionally, account receivable turnover can be converted into the number of days it takes to collect receivables by computing the average collection period is computed by dividing 365 (the number of days in a year) by the accounts receivable turnover formula as below:
Average collection period = 365 ÷ Accounts receivable turnover
The average collection period measures the average number of days it takes to collect a credit sale; equal to 365 divided by accounts receivable turnover.
Analysis frequently uses the average collection period to assess the effectiveness of a company’s credit and collection policies. The general rule is that the collection period should not greatly exceed the credit term period.
