Accounts Receivable Turnover

The accounts receivable turnover ratio formula is net credit sales divided by average accounts receivables. A higher AR turnover ratio means a company is efficiently collecting its accounts receivable, leading to more cash on hand.

What is Accounts Receivable Turnover?

Accounts receivable turnover ratio, also called the debtor’s turnover ratio, measures how efficiently a company is collecting its revenue. When a customer buys your product or service on credit, an accounts receivable (AR) balance is created.
This ratio (also called AR turnover or ART) measures the number of times a year that a company collects its average accounts receivable balance. All things equals, a higher accounts receivable turnover means a business is being run more efficiently. This metric is important to managing the available cash on hand.

The accounts receivable turnover formula is:

AR Turnover = Net Credit Sales / Average Accounts Receivable

The accounts receivable turnover formula is net credit sales divided by average accounts receivable for the accounting period.
Note that we are using net credit sales, not total revenue or net sales here. You only want to include the net sales that were made on credit in this calculation (since cash sales were settled instantly).

Net credit sales is total credit sales minus sales returns and sales allowances.

Similarly, the accounts receivable balance is constantly changing so we need to calculate the average for the period we are evaluating. AR turnover ratio is measured on a monthly, quarterly, or annual basis.

A high ratio means that a company converts accounts receivable to cash faster. Ideally, this is done by having a lower AR balance (lower denominator). A low ratio means that a company is slower at collecting its cash.

When ART is high and consistent, then the company’s cash flow is predictable and its balance sheet is healthier. When ART is low and consistent, the company might struggle to generate enough cash to cover its costs.

If ART is inconsistent, the company could suffer from an unexpected shortage of cash and it’s more difficult to forecast the future value of cash, accounts receivable, and other asset balances.

Accounts Receivable Turnover Formula

There are two ways of doing the AR turnover ratio calculation. If you are given average accounts receivable, you can use the following accounts receivable turnover ratio formula:

AR Turnover = Net Credit Sales / Average Accounts Receivable

If you are not given average AR, use the following formula:

AR Turnover = Net Credit Sales / ((Beginning Accounts Receivable + Ending Accounts Receivable) / 2)

When calculating the average values, you need to match the time period of the ratio to the beginning and ending balances in the formula. For instance, if you would like to find the accounts receivable turnover for May 2021, you must use May 1st and May 30th values.

To calculate the ratio for the fiscal year 2021, you would use an average across the year 2021. A precise way of calculating a yearly turnover would be getting an average for each month, then using those 12 values to create an average for the entire year.

Accounts Receivable Turnover Examples

Now that we know the definition of accounts receivable turnover, let’s dig into how to calculate the ratio by evaluating the performance of Company A and Company B.

Company A FY2021

  • Net Sales: $1,800,000
  • Net Credit Sales: $1,400,000
  • Average Accounts Receivable Balance: $330,000

Company B FY2021

  • Net Sales: $2,000,000
  • Net Credit Sales: $2,000,000
  • Starting Accounts Receivable: $750,000
  • Ending Accounts Receivable: $825,000

Let’s get started with Company A.

ART = Net Credit Sales / Average Accounts Receivable

ART = $1,400,000 / $330,000

ART = 4.24x

As a reminder, when calculating ART for Company A, you should use credit sales as the numerator. Since we are given the average, we can use the single version of the formula.

Now let’s dive into the math for Company B.

ART = Net Credit Sales / ((Beginning Accounts Receivable + Ending Accounts Receivable) / 2)

ART = $2,000,000 / (($750,000 + $825,000) / 2)

ART = $2,000,000 / ($1,575,000 / 2)

ART = $2,000,000 / $787,500

ART = 2.54x

For Company B, we were given the beginning balance and ending balance so we need to calculate the average ourselves. Thankfully everything was given on a yearly basis (beginning of the year, end of the year) so no further calculations were needed.

Looking at both values, we find that Company A is much more efficient at collecting cash. Company B makes 100% of its sales on credit but has a low accounts receivable turnover ratio, meaning they are in a tough spot.

Since they collect no sales on a cash basis, they need to be more mindful about recovering their accounts receivable from their customer base.

Days Sales Outstanding (DSO)

Days Sales Outstanding (DSO) measures the average number of days that a company needs to collect its credit sales. This metric is related to AR turnover ratio as both show how quickly a company can collect its receivables.

The days sales outstanding formula is:

DSO = (Average Receivable / Net Credit Sales) x 365 days

While ART is expressed as a multiple, DSO is expressed in the number of days. Here is an example of days sales outstanding.

Company A FY2021

  • Net Credit Sales: $7,500,000
  • Average Accounts Receivable: $2,500,000

We only need the two values above to calculate this formula for a given accounting period. While the output is always calculated in days, we could measure the formula for a month, quarter, or year.

DSO = (Average Receivable / Net Credit Sales) x 365 days

DSO = ($2,500,000 / $7,500,000) x 365 days

DSO = 0.333 x 365 days

DSO = 121 days

This metric shows us the average number of days it takes to collect AR. Given that Company A needs 121 days to collect cash, this is problematic particularly if they need to pay vendors every 30 days. Company A would benefit greatly by reducing this time.

The days sales outstanding formula is average accounts receivable divided by net credit sales multipled by 365 days.

AR Turnover vs. AP Turnover

In the same way that accounts receivable and accounts payable are related, it’s important for businesses to understand both their accounts receivable turnover ratio and accounts payable turnover ratio.
Accounts payable turnover ratio shows the time it takes for a company to pay its suppliers. The metric is also referred to as AP turnover ratio, AP turnover, or APT.

The AP turnover formula is:

APT = Total Supplier Purchases / Average AP

Companies will want to extend these payment terms to keep more cash on hand, but will need to balance this goal with keeping their suppliers happy. Being too slow on repaying partners could lead to extra penalties and fees, or worse.

Final Thoughts

Accounts receivable turnover ratio is an efficiency ratio that compares a company’s net credit sales to their average accounts receivable balance.

Credit sales are generated when a company performs a service or sells a product but does not collect cash right away. Typically, invoices are generated and must be paid thirty days after the invoice date.

That said, longer purchases might have payment terms that extend for 60, 90, or 120 days.

A company could extend credit in order to increase revenue but must balance this with collecting enough cash to serve customers, pay employees, cover overhead, and more. That’s where AR turnover ratio enters the picture.
AR turnover is a metric that helps management understand their efficiency in turning AR into cash. All things equal, a company wants an AR turnover that is high and consistent period over period.

Looking at ART over multiple periods is helpful to spot any harmful trends, like ART slowly declining.

A high turnover ratio means that a company sells mostly on cash, has a conservative credit policy, or is very efficient at collecting its cash from credit sales.

Meanwhile, a low turnover ratio means that a company has a poor collection process, is extending credit for too long, or has customers that are chronically paying invoices late.

The company could face financial difficulties if the AR turnover ratio gets too low and, in extreme cases, may even declare bankruptcy.

To improve your accounts receivable turnover, a company should evaluate its collection policies, evaluate reducing payment terms for all customers, and evaluate removing credit as an option for their worst offenders.

Management might look into accounting software and accounts receivable software in order to better manage the company’s accounts. When closing out the income statement and balance sheet, it’s worth taking the extra time to calculate these key financial ratios.

The bottom line is that receivable turnover ratio measures how efficient a company is at converting credit into cash. This is a valuable tool for businesses that are struggling with poor cash flow or need plenty of cash on hand to fund future growth.

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