What Is the Receivables Turnover Ratio?
The receivables turnover ratio is an accounting measure used to quantify a company's effectiveness in collecting its receivables or money owed by clients. The ratio shows 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. The receivables turnover ratio is also called the accounts receivable turnover ratio.
Receivables Turnover Ratio
Formula and Calculation of the Receivables Turnover Ratio
- Add the value of accounts receivable at the beginning of the desired period to the value at the end of the period and divide the sum by two. The result is the denominator in the formula (average accounts receivable).
- Divide the value of net credit sales for the period by the average accounts receivable (A/R) during the same period.
- Net credit sales are the revenue generated from sales that were done on credit minus any returns from customers.
- The accounts receivable turnover ratio is an accounting measure used to quantify a company's effectiveness in collecting its receivables or money owed by clients.
- A high receivables turnover ratio can indicate that a company’s collection of accounts receivable is efficient and that the company has a high proportion of quality customers that pay their debts quickly.
- A low receivables turnover ratio might be due to a company having a poor collection process, bad credit policies, or customers that are not financially viable or creditworthy.
- A company’s receivables turnover ratio should be monitored and tracked to determine if a trend or pattern is developing over time.
What the Receivables Turnover Ratio Can Tell You
Companies that maintain accounts receivables are indirectly extending interest-free loans to their clients since accounts receivable is money owed without interest. 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 receivables turnover ratio measures the efficiency with which a company collects on their receivables or the credit it had extended to its customers. The ratio also measures how many times a company's receivables are converted to cash in a period. The receivables turnover ratio could be 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. Also, companies can 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 what's the normal or average turnover ratio for that sector. If one company has a much higher receivables turnover ratio than the other, it may prove to be a safer investment.
High Receivable Turnover
A high receivables turnover ratio can indicate that a company’s collection of accounts receivable is efficient and that the company has a high proportion of quality customers that 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 policy can be beneficial since it could help the company avoid extending credit to customers who may not be able to pay on time.
On the other hand, if a company’s credit policy is too conservative, it might drive away potential customers to the competition who will extend them credit. If a company is losing clients or suffering slow growth, they might be better off loosening their credit policy to improve sales, even though it might lead to a lower accounts receivable turnover ratio.
Low Accounts Turnover
A low receivables turnover ratio might be due to a company having a poor collection process, bad credit policies, or customers that are not financially viable or creditworthy.
Typically, a low turnover ratio 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.
Example of How to Use the 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 January 1st or the beginning of the year.
- $72,000 in accounts receivables on December 31st or at the end of the year.
We can calculate the receivables turnover ratio in the following way:
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 the ratio of 11.76 by 365 days to arrive at the average duration. The average accounts receivable turnover in days would be 365 / 11.76 or 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. It's important for companies to know their receivables turnover since its directly tied to how much cash they'll available to pay their short term liabilities.
The Difference Between Receivables Turnover and Asset Turnover
The asset turnover ratio measures the value of a company's sales or?revenues?relative to the value of its?assets. The asset turnover ratio is an indicator of the efficiency with which a company is using its assets to generate revenue. The higher the asset turnover ratio, the more efficient a company. Conversely, if a company has a low asset turnover ratio, it indicates it's not efficiently using its assets to generate sales.
The accounts receivable turnover ratio measures a company's effectiveness in collecting its receivables or money owed by clients. The ratio shows how well a company uses and manages the credit it extends to customers and how quickly that short-term debt is collected or being paid.
Limitations of Using the Receivables Turnover Ratio
Like any metric attempting to gauge the efficiency of a business, the receivables turnover ratio comes with a set of limitations that are important for any investor to consider before using it.
A limitation to consider is that some companies use total sales instead of net sales when calculating their turnover ratio, which inflates the results. While this is not always necessarily meant to be deliberately misleading, investors should try to ascertain how a company calculates its ratio or calculate the ratio independently.
Another limitation of the receivables turnover ratio is that accounts receivables can vary dramatically throughout the year. For example, companies that are seasonal will likely have periods with high receivables along with perhaps a low turnover ratio and periods when the receivables are fewer and can be more easily managed and collected.
In other words, if an investor chooses a starting and ending point for calculating the receivables turnover ratio arbitrarily, the ratio may not reflect the company's effectiveness of issuing and collecting credit. 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.
Any comparisons of the turnover ratio should be made with companies that are in the same industry, and ideally, have similar business models. Companies of different sizes may often have very different capital structures, which can greatly influence turnover calculations, and the same is often true of companies in different industries.
Lastly, a low receivables turnover might not necessarily indicate that the company’s issuing of credit and collecting debt is lacking. 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 receivable, which would decrease the company’s receivables turnover ratio.