In today's video, I'm going to explain how accounts receivable turnover ratio works,
including the formula, an example calculation, and how to improve your turnover ratio.
I'm Priyanka Prakash, small business expert and senior staff writer at Fundera.
Accounts receivable turnover ratio basically tells you how good a job your business does
at collecting on invoices.
Many small business owners, especially B2B businesses, bill their customers using invoices.
Customers normally get a specific period of time 30, 60, or 90 days to pay those invoices.
The faster customers pay you, the better it is for your business's cash flow and financial
health.
Let's dive right into the accounts receivable turnover ratio formula.
Accounts receivable turnover ratio equals your net credit sales divided by your average
accounts receivable. in this formula, net credit sales means the portion of your annual
sales that are tied up in invoices.
Instead of receiving immediate payment for the sales, you extend credit to your customers
for these sales.
To get net credit sales, you take your gross sales and subtract cash sales, customer returns,
and other allowances for customers such as price changes.
Average accounts receivable refers to the average amount of money that customers owe
to you throughout the year.
To get this number, you can take the dollar amount of accounts receivable that you had
at the opening of the year, and add the dollar amount of accounts receivable that you had
at the end of the year.
Then, divide this sum by two to get the average accounts receivable.
Now, accounts receivables are considered assets, so you can find all the numbers that you need
for this formula on your business's balance sheet.
Let's go through an example to better understand how accounts receivable turnover ratio works.
Here's a balance sheet for a fictional business, ABC Bakery, that shows the start-of-year assets
and liabilities and end-of-year assets and liabilities.
To calculate the accounts receivable turnover ratio, I only care about the accounts receivable
row on the balance sheet.
In this case, ABC Bakery started the year with $15,000 in accounts receivable and ended
the year with more money—$30,000—in accounts receivable.
This shift can happen if your company has an uptick in sales as the year is ending.
Let's assume that ABC Bakery also had $100,000 in net credit sales for the full year.
To calculate the accounts receivable turnover ratio for ABC bakery, first calculate the
average accounts receivable.
Add up the opening year accounts receivable—$15,000—and the end of year accounts receivable—$30,000—and
divide by two to get the average accounts receivable—$22,500 in this case.
Next, plug your numbers into the accounts receivable turnover ratio formula.
Take the net credit sales of 100,000, and divide by the average accounts receivable—$22,500—to
get 4.44.
This number means that ABC Bakery’s accounts receivable turned over 4.44 times in the past
one year.
If you take the 365 days in a year and divide by this accounts receivable turnover ratio,
you get 82.
That means it took on average 82 days for ABC Bakery to collect on each invoice.
So what makes a good accounts receivable turnover ratio?
Ideally, your business shouldn't take longer than 30 days on average to collect on each
invoice.
The ideal amount of time of course could differ based on industry and the stage of your business's
growth.
But in general, a higher accounts receivable turnover ratio is usually better than a low
ratio.
A business with a high accounts receivable turnover ratio tends to have stricter credit
policies and is more efficient at credit collection.
If you have a low accounts receivable turnover ratio, it usually means that your credit policies
are not strict enough or that you're having issues with the debt collection.
Less commonly, a low accounts receivable turnover ratio could mean that there was a problem
with a particular shipment of goods that led more of your customers to refuse payment,
so don't necessarily blame your credit collection staff for a low turnover ratio.
Now, the best way to improve your accounts receivable turnover ratio is to have and follow
sound credit collection policies.
Basically, your goal is to get clients to pay you as soon as possible.
These are a few tips to encourage your customers to pay invoices more quickly: Send your invoice
immediately after a job is complete; Give clients online payment options to reduce the
friction of payment; Offer clients early payment discounts and charge late fees so clients
feel pressure to pay you faster; Ask for deposits upfront: Send periodic friendly payment reminders
to your clients; And don't work with habitually late paying clients.
For more advice on how to improve your accounts receivable turnover ratio, also check out
our video about unpaid invoices.
In that video, we cover several strategies to collect on debts more quickly.
After watching this video, you should now know how to calculate your accounts receivable
turnover ratio.
This ratio gives you a good look at an important part of your business’s cash flow.
It's a good idea to check your accounts receivable turnover ratio at least once per quarter,
maybe even more often, so you can take steps to improve credit collection if there's a
decline in your ratio.
For more small business finance tips, visit fundera.com.
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