Your accounts receivable (AR) turnover ratio is an essential element of the accounting process. Find out, in this article, what makes the AR turnover ratio tick and how to calculate this for your company. Learn how to make better gains with your business by using this key metric for a performance standard.
What are Accounts Receivable?
The vast majority of businesses sell products and services to clients on credit. This means the value offering is not paid for at the time it is provided. Rather, the service or product provider issues a bill that is eventually paid by the client. This payment is processed through the provider’s accounts receivable department.
Accounts receivable are the account within financial books that keep track of the entirety of money owed by customers. The money owed to a business is usually collected in a specific period of time, be it a couple of weeks, a month, or longer. The expectation is that the money owed will be paid.
Therefore, money owed to the business is recorded as an asset on the balance sheet. This means accounts receivable is used as an integral component of the accrual basis method of accounting. The logic in categorizing accounts receivable as an asset is the money owed is likely to be paid within a reasonable amount of time and provide value to the business.
What is the AR Turnover Ratio?
The accounts receivable (AR) turnover ratio in accounting comes from accounts receivable and net credit sales. This ratio starts with the number of products or services businesses lend to customers as credit. As a business owner, your accounts receivable figures are the mainstay of this calculation. You need to know exactly how much money is owed to your company in accounts receivable. Technically, this is a loss for your company until the money is recouped.
While some businesses send out invoices to remind customers of debts owed, along with payment terms accordingly, not all companies have credit policies or collection processes in place. This can be a problem, which is why you first need to know what the AR turnover ratio is for your company. From there, depending on how high the ratio is, you may need to enact some policies and make moves to slow down new accounts and get money coming back your way.
How to Calculate the AR Turnover Ratio
Now let’s get right to the nitty-gritty of calculating a receivables turnover ratio.
Start with the net credit sales amount. This is your sales returns plus your sales allowances combined and then subtracted from the annual credit sales total. Once you have calculated these figures, you have the net credit sales amount.
Next, calculate the average accounts receivable. Total up outstanding invoices and credits to customers. You can find the average by adding up these numbers and dividing the sum by two.
Finally, find the accounts receivable turnover ratio by dividing the net credit sales amount by the average accounts receivable. The final answer is the accounts receivable turnover ratio.
Net Credit Sales Amount / Average AR = AR Turnover Ratio
How to Use the Accounts Receivables Turnover Ratio
To use this ratio for your business, start measuring the AR turnover ratio every so often, i.e., quarterly or monthly. Compare these figures side by side for each period to see how your business is shaping up. You can also use this for calculating collections for client invoices. Here’s how:
Use the AR turnover ratio to find out the average owed to your company during any collection period. Typically, the collection period is every month or 30 days. To find this, divide this number of days by the AR turnover ratio. This will give you the total average of how long it takes to pay for goods or services or to pay off an invoice.
For comparison, if you have a two-week collection period, this means customers tend to pay for items within 14 days. As an industry-standard, this indicates a good ratio for credit extended to customers.
Anywhere between two weeks and four weeks (a month) is considered average for a company in any niche. Generally, manufacturers extend services for a month per invoicing for the best results with customer service.
Finding a solid ground for your customer invoices is important to maintain a steady stream of revenue. Otherwise, you will end up over your head with credits extended to customers who might not actually end up paying for the debt. This is what cripples businesses of all sizes, but especially startups that are trying to stay afloat.
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