As a CFO of a mid-sized manufacturing company, you’re always under pressure to improve your company’s financial metrics as your company has been experiencing cash flow issues.
Your biggest concern is how long customers take to pay their invoices. But worry not—understanding and optimizing your Accounts Receivable (AR) Turnover Ratio is your key to unlocking more efficient cash flow management for your company.
In this guide, we’ll explore the AR Turnover Ratio in-depth, providing you with the knowledge you need to enhance your company’s financial health.
What is the AR Turnover Ratio?
The Accounts Receivable (AR) Turnover Ratio is an efficiency ratio that companies use to measure how effectively. They collect their receivables or the credit they have extended to customers. AR Turnover Ratio reflects how often a company collects its average receivables during a specific period, typically a year.
This ratio is crucial because it provides insight into a company’s liquidity of receivables. If the company is not quickly converting its receivables into cash, it could face challenges in meeting its short-term obligations.
The AR Turnover Ratio is a critical indicator of a company’s ability to manage its credit policy and customer relationships. It helps businesses understand the frequency at which they convert receivables into cash, directly impacting liquidity and operational efficiency.
For example, a company with a high AR Turnover Ratio likely has a disciplined credit policy. It can efficiently collect debts, maintain healthy cash flow, and reinvest that cash into the business. Conversely, a low ratio might indicate issues in credit management, which could lead to cash flow problems and impact the company’s ability to fund operations.
How to Calculate the AR Turnover Ratio?
AR Turnover Ratio can be calculated with a simple formula:
| Accounts Receivable Turnover = Net Credit Sales/ Average Accounts Receivable |
This basic formula provides a straightforward method for calculating the AR Turnover Ratio. However, understanding the formula’s components can help you calculate and interpret the ratio accurately.
Net Credit Sales: Net Credit Sales represent the total sales made on credit during the period, excluding any returns or allowances. It is a key figure because it reflects the revenue the company expects from customers over time.
- Sales on Credit: Sales where the customer is allowed to pay at a later date rather than at the point of sale.
- Sales Returns and Allowances: These are deductions from total sales for products returned by customers or allowances given for defective goods.
Average Accounts Receivable: This figure represents the average amount of receivables outstanding during the period. It is calculated by adding the beginning and ending balances of accounts receivable for the period and dividing by two.
- Beginning Accounts Receivable: The outstanding receivables at the start of the period.
- Ending Accounts Receivable: The outstanding receivables at the end of the period.
By using these components, you can easily calculate the AR Turnover Ratio to assess the efficiency of a company’s credit and collections processes.
Calculation and Example:
Let’s take a look at step-by-step calculation to understand it more clearly.
Step 1: Determine Net Credit Sales
To determine the Net Credit Sales, you can calculate the total credit sales for the period. This figure should exclude any cash sales, as the focus is on receivables. Once done, you can subtract any returns and allowances from this figure to get the Net Credit Sales.
Step 2: Calculate the Average Accounts Receivable
Next, you can add the receivable balances of the beginning and end accounts and find the average for the period.
Step 3: Compute the Accounts Receivable Turnover Ratio
Finally, you can divide the Net Credit Sales by the Average Accounts Receivable. The resulting figure is the AR Turnover Ratio, indicating how many times the company collects its receivables during the period.
Let’s consider a simple example to illustrate how to calculate the AR Turnover Ratio using hypothetical data:
- Annual Net Credit Sales: $120,000
- Beginning Accounts Receivable: $30,000
- Ending Accounts Receivable: $40,000
- Average Accounts Receivable: ($30,000 + $40,000) / 2 = $35,000
Now, apply the formula:
Accounts Receivable Turnover Ratio = $120,000 / $35,000 ≈ 3.43
This ratio indicates that the company collects its average receivables about 3.43 times yearly.
In this example, the company’s AR Turnover Ratio of 3.43 suggests it takes approximately one-third of a year, or about 106 days (will see its interpretation in detail in the next section), to collect its receivables. This ratio is neither exceptionally high nor low, but its adequacy would depend on industry norms and the company’s specific financial strategy.
How to Interpret the AR Turnover Ratio?
Interpreting the AR Turnover Ratio is extremely important for making informed business decisions. The ratio’s significance varies depending on whether it is high or low, and it must always be contextualized within the industry.
High Ratio:
A higher AR Turnover Ratio is generally positive, indicating that the company efficiently collects its receivables. This efficiency could result from a conservative credit policy, where the company extends credit only to customers with strong credit histories, thereby reducing the risk of non-payment.
High turnover is often associated with:
- Efficient collection processes: The company has robust mechanisms for following up on outstanding invoices.
- High-quality customers: The customer base consists of financially stable clients who pay their bills promptly.
- Conservative credit policy: The company may extend credit only to the most creditworthy customers, minimizing the risk of bad debts.
- Effective debt management: The company actively manages its receivables, ensuring that outstanding debts are collected in a timely manner.
Pro tip: However, it’s essential to note that an excessively high ratio might suggest that the company is too strict with its credit policies, potentially missing out on sales opportunities by not extending credit to a broader customer base.
Low Ratio:
A lower AR Turnover Ratio may indicate a slow collection process, potentially due to less creditworthy customers or overly lenient credit terms. It can reduce cash flow, making it difficult for the company to meet its obligations and invest in growth opportunities.
A low ratio could result from:
- Inefficient collection processes: The company may not have adequate systems to ensure timely payments.
- Less creditworthy customers: The customer base may include clients with poor payment histories, leading to delayed collections.
- Overly lenient credit terms: Offering too generous payment terms might lead to delays in collecting receivables, affecting cash flow.
- Potential liquidity problems: Converting receivables into cash could result in liquidity challenges, affecting the company’s ability to fund day-to-day operations.
Industry Comparison:
It’s essential to compare the AR Turnover Ratio against industry benchmarks. Different industries have varying norms for receivable collection periods, so a ratio that appears high or low must be contextualized within the specific industry.
For example:
- Retail industry: Typically, the retail sector has a higher AR Turnover Ratio due to the nature of cash sales and fast-moving inventory.
- Construction industry: On the other hand, the construction industry may have a lower ratio because of its longer payment terms and project-based billing.
Understanding these variations can help a company effortlessly interpret its AR Turnover Ratio and make necessary strategic adjustments.
Why Use AR Turnover in Days?
The AR Turnover in Days metric converts the turnover ratio into the average number of days it takes for a company to collect its receivables. This conversion provides a more tangible and understandable measure of collection efficiency.
By expressing the turnover ratio in days, companies can better visualize their collection cycles and assess whether they align with their financial objectives. This metric is handy for businesses that need to manage cash flow tightly.
You can easily calculate receivable turnover in days by a simple calculation:
Receivable Turnover in Days= 365 / Receivable Turnover Ratio
This formula calculates the average number of days it takes for a company to collect its receivables based on its AR Turnover Ratio.
Let’s understand it more with an example;
Using our previous example, with an AR Turnover Ratio of 3.43:
For a turnover ratio of 3.43, AR Turnover in Days = 365 / 3.43 ≈ 106 days
This result implies that, on average, it takes 106 days to collect receivables.
What are the Implications of AR Turnover in Days?
- Cash Flow Planning: A longer collection period means that cash is tied up in receivables for an extended period, potentially leading to cash flow constraints.
- Credit Policy Evaluation: If the AR Turnover in Days is significantly longer than the company’s payment terms, it may indicate issues with credit policies or customer payment practices.
- Operational Efficiency: A shorter collection period suggests that the company effectively manages its receivables, which can lead to improved liquidity and operational efficiency.
What are its Applications in Financial Modeling?
The AR Turnover Ratio is essential for financial modeling, especially in forecasting balance sheets and managing cash flows. It helps calculate the period required to collect revenue, impacting financial planning and decision-making.
In financial models, the AR Turnover Ratio projects future accounts receivable and cash flow. By understanding how quickly the company collects receivables, financial analysts can better predict when cash will be available to cover expenses, invest in new opportunities, or pay down debt.
For instance, let’s consider a company that projects $500,000 in credit sales for the next quarter. By analyzing the AR Turnover Ratio, the company can estimate how long it will take to collect these sales, which helps in cash flow forecasting.
- Balance Sheet Impact: The ratio helps estimate the receivable balance of the ending accounts, which is a key component of the balance sheet.
- Cash Flow Forecasting: By predicting when receivables will be collected, the company can better manage its cash flow, ensuring that it has sufficient liquidity to meet its obligations.
- Working Capital Management: Understanding the AR Turnover Ratio allows the company to optimize its working capital by balancing receivables, payables, and inventory.
In this way, the AR Turnover Ratio is not just a static metric but a dynamic tool that plays a crucial role in financial modeling and decision-making.
How to Improve the AR Turnover Ratio?
Improving the AR Turnover Ratio can enhance cash flow and overall financial health. Here are some strategies you can use to improve it:
- Efficient Invoicing: Ensure invoices are issued promptly and accurately, reducing delays in the payment process. Automation tools can streamline invoicing, ensuring that invoices are sent out when the sale is made.
- Multiple Payment Methods: Offering various payment options can make it easier for customers to pay and speed up the collection process. These might include credit card payments, online payment portals, and electronic funds transfers (EFT).
- Clear Payment Terms: Clearly define payment terms in contracts to prevent ambiguity and reduce the likelihood of delays. This includes specifying due dates, late payment penalties, and any discounts for early payment.
- Proactive Reminders: Regularly send payment reminders to customers before and after due dates to encourage timely payments. Automated reminder systems can help maintain consistent customer communication, reducing the likelihood of overdue payments.
- Early-Payment Discounts: Provide discounts for customers who pay early, incentivizing quicker payments and improving cash flow. For example, offering a 2% discount for payments made within ten days can encourage customers to pay sooner.
- Credit Policy Review: Regularly review and adjust the company’s credit policy to align with current market conditions and customer behaviors. Tightening credit terms for new customers or those with poor payment histories can reduce the risk of late payments.
- Customer Creditworthiness Assessment: Assessing customers’ creditworthiness before extending credit can help minimize non-payment risk. This might involve conducting credit checks or analyzing payment histories.
- Collections Process Optimization: Streamlining the collections process, including establishing a clear escalation path for overdue accounts, can improve the AR Turnover Ratio. This might involve working with a collections agency or implementing stricter internal collection policies.
By implementing these strategies, companies can improve their AR Turnover Ratio, leading to better cash flow management and financial stability.
What are the Limitations of the AR Turnover Ratio?
While the AR Turnover Ratio is a valuable tool, its limitations should be considered in analysis and decision-making.
- Contextual Relevance: The ratio must be interpreted within industry standards and economic conditions. A high ratio might not always be beneficial if it results from overly strict credit policies that limit sales. Similarly, a low ratio might be acceptable in industries with standard extended credit terms.
- Extreme Values: Unusually early or late payments can distort the ratio, giving a misleading impression of the company’s actual collection efficiency. For example, a company collecting a significant payment early in the period might artificially inflate the AR Turnover Ratio.
- Seasonal Businesses: For businesses with significant seasonal fluctuations, the AR Turnover Ratio may vary widely throughout the year, making it less useful as a standalone metric. Companies with seasonal sales cycles may need to calculate the ratio on a rolling basis or compare it yearly to gain a more accurate understanding.
- Single-Period Focus: The AR Turnover Ratio typically focuses on a single period, such as a year, which may not provide a complete picture of the company’s long-term collection trends. Analyzing the ratio over multiple periods can help identify patterns or changes in customer payment behavior.
How does Bunker Help?
Bunker is your biggest ally in optimizing accounts receivable management. It allows you to identify problem customers and strategically plan your cash flow runway. With features like automated reminders and insightful dashboards, Bunker makes managing your receivables easier and more efficient.
Accounts Receivables Dashboard: Bunker provides a comprehensive Accounts Receivables Dashboard that empowers you with critical insights, including:
- Risk Level Assessment: Clearly assess the risk associated with each customer based on factors like concentration, credit history, and overdue receivables. This helps you prioritize follow-ups and adjust your credit policies accordingly.
- Expected Fund Inflows: Intuitively visualize expected fund inflows from receivables at any given time, enabling better cash flow forecasting and planning.
- Key Metrics Tracking: Bunker’s AR dashboard allows you to monitor essential metrics, including:
- Receivables and Overdue Receivables: Bunker provides a comprehensive overview of the current AR situation. Gain a comprehensive overview of your current accounts receivable situation, identify outstanding invoices and assess overall cash flow health.
- Blended Days Sales Outstanding (DSO): This Key performance indicator measures your AR efficiency, helping you understand how quickly you collect customer payments.
- AR Aging: This feature offers visibility into expected future cash inflows. You can gain valuable insights into the aging of your receivables, which can help you manage cash flow more effectively.
- Top Customers: This Feature highlights concentration risk and identifies key accounts to monitor, ensuring that your most important customers pay on time and maintain healthy relationships.
Leveraging Bunker’s tools and insights can enhance your collection processes, reduce risk, and ultimately improve your cash flow management.So, are you ready to take control of your accounts receivable and boost your cash flow? Discover how Bunker can transform your collections process. Sign up for a free trial or Book a demo today!
