The accounts receivable turnover ratio is an important efficiency metric used by management and investors to understand how many times a business converts its receivables to cash over a period of time. It is often used to compare multiple companies across the same industry or sector to identify which ones are best at converting customer credit to cash.
Because cash is so important, both corporate and investment finance professionals monitor accounts receivable turnover regularly to identify if a business faces potential liquidity or solvency issues.
In this post we will cover what the accounts receivable turnover ratio is, how to calculate accounts receivable turnover, and how to interpret the results.
What Is The Accounts Receivable Turnover Ratio?
The accounts receivable turnover ratio is a calculation that compares the net credit sales over a period of time to the average accounts receivable balance for the same period. The end result is a ratio that quantifies how effective a business is at collecting its receivables. At its core, the ratio tells us how many times a business converted its receivables to cash over a period of time.
The ratio is also a measurement of how long it takes a business to convert credit sales to cash over a given period of time. One of the benefits of ratio analysis is that it allows analysts to compare multiple companies across the same sector and industry.
In general, as a business becomes more efficient at converting credit sales to cash the accounts receivable turnover ratio is higher. This makes the ratio intuitively easy to understand when comparing multiple companies across the same industry.
How To Calculate The Accounts Receivable Turnover Ratio
The formula for calculating accounts receivable is:
AR Turnover Ratio = Net Credit Sales ÷ Average Accounts Receivable
Earlier we mentioned that the accounts receivable turnover ratio takes into account time. The way it does this is by establishing a period of time for average accounts receivable and net credit sales.
For example, if a business is calculating its accounts receivable turnover for a 90-day period, it would take the net credit sales over the 90-day period and divide it by the average accounts receivable balance for the period.
The simplest way to calculate average accounts receivable would be to sum the beginning and ending accounts receivable balances and divide by two.
How To Interpret The Accounts Receivable Turnover Ratio
Accounts receivable is the result of the accrual method of accounting, which requires a business to recognize revenue and expenses in the period they were incurred, not necessarily received. The timing differences between when revenue is generated and received create a balance due from customers. The amounts due from customers for services and goods rendered are represented on the balance sheet as accounts receivable.
Therefore, it is imperative that business leaders work to actively convert these balances into cash. When calculating the accounts receivable turnover ratio. Earlier we mentioned that the higher the ratio the better.
By examining the components of the formula, we can see why. Net credit sales for the period are divided by average accounts receivable for the same period, so the end result of the formula is the number of times the business has converted its credit sales to cash.
Holding net credit sales equal, as average accounts receivable decreases, the resulting ratio is larger. A simple example demonstrates this relationship:
Net Credit Sales = 100,000
Average AR = 25,000
Accounts Receivable Turnover = 100,000 / 25,000 = 4.0
In this example, receivables were converted to cash four times throughout the period.
Understanding the relationship between credit sales and average accounts receivable is important because businesses work to both increase sales and actively manage their accounts receivable.
Therefore, holding average accounts receivable equal, the higher the credit sales, the higher the resulting ratio.
This is why the ratio is considered an efficiency measure, as it measures the number of times that the business converted credit sales to cash. Businesses that are inefficient at converting accounts receivable balances to cash face liquidity risks and potential solvency problems.