Running a business requires a continuous assessment of operations followed up by strategic and informed modifications. That’s just a fancy way of saying you need to know every aspect of your business to avoid surprises and to make necessary changes. There are several tools you can use to do this, one of them being the accounts receivable turnover ration. Despite the relatively long name, it is actually very easy to calculate and will give you some very useful insights about your business. When reviewing your Accounts receivable aging report to forecast your cash flow its important to understand the account receivable ratio and find ways to improve it.
What is the accounts receivable turnover to be exact?
Very simply, the accounts receivable turnover is a ratio used to compare how well your business issues credit to its customers and how effective it is at collecting those debts. It is nearly impossible to run a business without issuing a credit to your customers, you probably do the same with your suppliers, but the idea is to make sure you collect that debt. Otherwise, your cash flow will suffer and running the business will become difficult.
The accounts receivable turnover thus helps you determine if your business is good at collecting debts from customers and if not, where to make some changes. Not only does this help your business operations, but will also be a factor when you’re ever applying for a business loan. Therefore, it is very important to know how you can calculate the ratio on your own and understand your business even better.
How do you calculate the accounts receivable turnover ratio?
To find the ratio, you should use the formula:
net credit sales / average accounts receivable
The net credit sales section represents all revenue generated by the business as a result of sales made on credit by its customers. For that reason, the number should not include any revenue generated from cash sales. Also exempt from the value should also be sales returns and allowances. Sales returns and allowances are issued to customers due to problems with shipment, services or transactions, which is why they are not included in the net credit sales figure.
You should be easily able to calculate the net credit sales from the balance sheet or income statement using this formula:
sales on credit – sales returns – sales allowances
Once you have the above figure, move on to the second part – average accounts receivable. This is the amount of money your business is owed by its customers. Values for accounts receivables should also be available from the balance sheet. The accounts receivable turnover is usually calculated over an annual period, so you should also find the average accounts receivable over a period of a year. To do so, add the accounts receivable numbers from the balance sheet at the start and at the end of the year, then divide it by 2 to find the average. You can use this formula:
(beginning accounts receivable + ending accounts receivable) / 2
With these two figures in hand, simply divide the two to find the final result using the formula shown above.
How about an example?
Although the formula is quite simple, it is always easier to understand through a hypothetical example. Consider a small business that manufactures car parts that had quite a good year with $1,500,000 in total revenue. Of this, $250,000 was comprised of cash sales while there was $50,000 in returns and $20,000 in allowances. The net credit sales would then be:
$1,500,000 – $250,000 – $50,000 – $20,000 = $1,180,000
At the start of the year, accounts receivable indicated $180,000 while the end of year value showed $240,000. Thus, average accounts receivable would be:
($180,000 + $240,000) / 2 = $210,000
Consequently, the company’s accounts receivable turnover would be:
$1,180,000 / $210,000 = 5.6
What does this Account Receivable Turnover number mean?
In the above example, a 5.6 accounts receivable turnover meant that the company turned over accounts receivable in 65 days throughout the year on average. If the value was, say, 11.2, it would mean that accounts receivables were turned over every 33 days or so. From this, you can tell that a higher accounts receivable turnover ratio means that a company is turning over its debt quicker and is more effective at collecting a debt.
Having a poor accounts receivable turnover ratio is not advisable because it generally signals that the business is not collecting what it is owed. If such a situation were to continue for several years, then the company would eventually have to write it off as bad debt. That is money lost from the business, and the cash flow will take a hit and operations would become more difficult. In the worst-case scenario, the business would have to shut down because there wouldn’t be enough money to pay for essential services and staff.
Because every business wants to have a high accounts receivable turnover ratio, it may be important to look at some of the factors that could affect the value.
Quality of customers
Companies are always keen to find out about their customers’ credit rating in order to establish whether they are going to pay their debt and how quickly they do so. When a company does not pay attention to this factor, it ends up issuing credit to bad customers who delay payment or completely foregoing payment. In the end, your company swallows the cost and suffers a loss, which is why it is so important to understand the quality of customers you lend to.
Debt collection
Even with an elite clientele, you will still need to put some effort in collecting what you are owed. Big companies have entire debt collection departments to ensure they are paid for the credit they extend. But even smaller companies can devise more effective ways of collecting debt rather than sit and wait.
Dependence on cash
Those businesses that depend mainly on cash will always have better accounts receivable turnover than credit businesses. This is something to consider once you’re done making your calculations.
Now that you know what it takes, you can make the necessary steps to improving your company’s accounts receivable turnover. On the other hand, you should not aim for the maximum accounts receivable turnover ratio either. To achieve such a feat would mean being very aggressive with your debt collection and turning down any potential customer with slightly lower credit rating. Of course, this is not what you want, and business is all about taking risks, but it’s just a matter of understanding what your risk appetite is.
Why is the accounts receivable turnover ratio important to know for your business?
With the accounts receivable turnover ratio in hand, you will know how well your business is at collecting debt. Knowing this should direct you on how you can improve your debt collection policies, filter less desirable clients in the future or both. In the end, it is all about improving the cash flow of your business because that is absolutely crucial to its success and even existence. For instance, you may decide to cut back on some expenses for some time until the ratio goes higher to ensure you have enough cash flow to run the business.
Besides debt, unsecured business loan providers also look at the accounts receivables as collateral instead of profit. By improving the accounts receivable turnover ratio, your business will be eligible for higher loans and at more favorable terms.
To make this formula even more effective for your business, always keep tracking it so that you can make consistent changes whenever necessary for the company’s financial health.
