How to Calculate the Receivable Turnover Ratio

How to calculate the receivable turnover ratio

If you are interested in finding out how to calculate the receivables turnover ratio, this is just the article for you. The accounts receivable turnover is an accounting factor used to measure the effectiveness of a company in getting its receivables.

The accounts receivable turnover defines the number of times that a business can collect its account average receivables in a year. Defining this term simply, an accounts receivable ratio measures a company’s ability to collect its money owed by clients.

What is the accounts receivable turnover ratio?

The accounts receivable turnover ratio is used to measure a company’s ability to give credits and claim payment on time. A low ratio value shows that there is an ineffective credit policy in the company. This represents an opportunity for the company to tidy up on old accounts that may have caused a limited working capital.

Aside from a non-functional policy, a loose policy can also cause inefficient retrieval of the credits. A low turnover level can be bad debt on the company’s capital or a pool of financially unstable customers.

To rectify the worsening accounts receivable ratio may require giving the staff a salary raise to improve efficiency. Also, placing a review of the company’s financial state can be a suitable option.

In some companies, to prevent having a low turnover for accounts receivable, bills are sent to customers ahead of. This may be a month in advance to ensure that the customers do not receive services without paying.

However, some facts should be considered concerning the accounts receivable of a company. Facts, such as:

• A high turnover ratio represents efficiency in a company’s method of retrieving debts from customers. Therefore, customers pay their debts quickly.
• Having a low turnover ratio does not always refer to a weak policy or financially unstable customers. Some business owners tend to have limits beyond 30 days and this may influence the level of accounts receivable.
• Monitoring a company’s turnover ratio is important to detect if a trend or pattern is being developed over time.

Calculating the accounts receivable turnover ratio

Calculating the accounts receivable turnover ratio is very simple and only requires some data. The accounts receivable turnover ratio is otherwise known as the “debtors turnover” ratio. This calculation is meant to evaluate the efficiency of the company’s credit policy or workers in retrieving debts.

This value is calculated relative to time and the period it takes the company to obtain the cash. The accounts retrievable ratio calculation is by dividing the value of the company’s net sales by average account receivables.

Mathematically, 

The accounts receivable turnover ratio = Net annual credit sales ÷ Average accounts receivable.

The net credit sales define the number of sales that were offered to customers on credit minus returns from customers. That is, if the customer has made any installment or payment, it is removed from the net credit value.

Calculating the average accounts receivable is by getting the mean of the starting and ending receivables. The time frame for measurement can be quarterly, monthly, or annually.

What is a good account receivable turnover ratio?

As emphasized in the facts above, having a higher ratio number is better. This signifies that the customers pay up their debts on time and the business working capital is not affected negatively.

Also, this shows that the method used for credit or debt collection is efficient. Although in some cases, this may be untrue, a high ratio can represent high income and a strong balance sheet.

Therefore, when the accounts receivable turnover ratio is high, it can be assumed to be in a ‘good’ state.

Notably, having a high turnover ratio is not always lucrative as it can represent either an efficient or a threatening method. That is, a company can get a high ratio due to its amazing collection policy or methods. Also, debts can be retrieved from customers by threatening them.

Both of these methods will yield a high turnover ratio but threatening customers can reduce sales and trust drastically. Companies and businesses should understand that sometimes having a low turnover ratio is not very bad. Extending the debt period not to lose customers to competitors can be very helpful.

Limitations of the accounts receivable turnover ratio

As relevant and important as this ratio can prove to be, it is limited in some cases. Although the account receivables turnover ratio can be used to analyze customers’ payment trends, it has limitations.

This calculation cannot be used to predict the financial state of a customer, whether or not they are bankrupt. It also cannot be used to determine when a company or business loses customers to competitors.

Furthermore, determining faithful and dedicated customers is not achievable with this ratio. Although these are important factors to maintaining a high turnover ratio.

Ways to improve the accounts receivable ratio

As a business, it is important to note that the ratio of accounts receivable can differ largely among sectors. However, it is important to maintain a high accounts receivable ratio. 

The first step to take to increase your AR ratio is by sending invoices to customers regularly. An invoice informs the customer of their debts and keeps them aware of their commitment. Mailing them a copy of an invoice that is accurately drafted is one of the ways to improve your turnover ratio.

Another method is sending a reminder; the commonest method for doing this is through e-mail marketing. This is a way to remind the customer of their debts and advertising your other franchise and services.

Informing the customers ahead of any change in policy or new terms will also get them to cooperate better. Give offers and discounts to them to intrigue them to pay up as early as possible. Finally, give them several means of payment to ease their burden.

These are ways to ensure that the customers pay on time without threats or force and increase the turnover ratio.

Conclusion

The accounts receivable ratio is a very important term in business and must be calculated for every business. Hopefully, this article has helped you with how to calculate the receivable turnover ratio for your business. It is important to know the procedure for this calculation to know how well your business responds to debtors. The ratio considers the rate at which a business can issue service on credit and obtain timely payment.