The accounts receivable turnover ratio (AR turnover ratio), also known as the debtors’ turnover ratio, is a metric used to assess a company’s efficiency in collecting payments from credit sales. It essentially measures how many times a company sells and collects its average accounts receivable balance within a specific period, typically a year.
Understanding AR Turnover
Focuses on Collection Speed: A higher AR turnover ratio indicates a company collects its credit sales faster, signifying better collection efficiency and healthier cash flow.
Efficiency Benchmark: By comparing the AR turnover ratio to industry averages or the company’s historical performance, you can gauge its collection efficiency relative to peers or its own past performance.
Calculating AR Turnover Ratio
The formula for calculating the AR turnover ratio is
AR Turnover Ratio = Net Credit Sales / Average Accounts Receivable
Net Credit Sales
Net Credit Sales represent the total revenue generated from selling products or services on credit during a specific period (usually a year). This is not the same as the total sales figure, which would include both cash and credit sales.
To calculate Net Credit Sales, start with the gross credit sales figure (total sales on credit before adjustments). Then, subtract any returns or allowances associated with those credit sales.
- Returns: These occur when customers return merchandise they purchased on credit. The returned amount is deducted from the original credit sale.
- Allowances: These are price reductions offered to customers for damaged goods, errors on invoices, or other reasons. The allowance amount is deducted from the original credit sale.
Average Accounts Receivable
This reflects the typical amount of money owed to the company by its customers on credit sales at any given time within a specific period. It provides an average picture of the outstanding AR balance throughout the period.
There are two common ways to calculate Average Accounts Receivable:
- Simple Average: This method adds the beginning and ending accounts receivable balances for the period and divides them by the number of periods (months in a quarter or quarters in a year).
Formula: Average AR (Simple) = (Beginning AR Balance + Ending AR Balance) / Number of Periods
- Weighted Average: This method assigns weights (usually based on the number of days in each period) to the ending AR balance for each period and then divides the sum of these weighted balances by the total number of days in the period. This approach provides a more accurate picture if the ending AR balance fluctuates significantly throughout the period.
The specific calculation for a weighted average AR involves more steps and can be found in accounting resources.
Interpreting AR Turnover Ratio
A higher AR turnover ratio is generally preferable as it indicates a faster collection of payments. However, it’s important to consider industry standards and context:
Industry Benchmarks
Certain industries naturally have longer payment cycles. Comparing your AR turnover ratio to industry averages can provide a more meaningful interpretation.
Company-Specific Factors
Factors like credit terms offered, customer base, and collection practices can influence the AR turnover ratio.
AR Turnover Ratio and Average Collection Period
The AR turnover ratio is closely related to the average collection period (ACP), also known as days sales outstanding (DSO).
| Feature | AR Turnover Ratio | Average Collection Period (ACP) |
| Focus | Collection Efficiency (Speed) | Collection Efficiency (Duration) |
| Interpretation | Higher ratio indicates faster collections | Lower number indicates faster collections |
| Formula | Net Credit Sales / Average Accounts Receivable | (Average Accounts Receivable / Net Credit Sales) x 365 |
| Result | Number of times AR is “turned over” in a period (e.g., year) | Number of days it takes to collect on average sales |
| Industry Comparison | Compared to industry benchmarks to assess relative efficiency | Compared to industry benchmarks to assess relative efficiency |
| Context | Consider credit terms offered and the customer base | Consider credit terms offered and the customer base |
| Relationship | AR Turnover Ratio = 365 / Average Collection Period | They are reciprocal concepts |
AR Turnover Ratio = 365 / Average Collection Period (ACP)
Therefore, a higher AR turnover ratio translates to a lower average collection period, indicating faster collections.
In conclusion, the accounts receivable turnover ratio is a crucial part of accounts receivable management and a valuable metric for businesses to assess their collection efficiency and cash flow management. By analyzing this ratio, businesses can identify areas for improvement in their credit and collection processes, ultimately leading to faster collections and a healthier financial bottom line.
To focus on core functions of the business, outsourcing accounts receivable is a good choice for businesses. A professional BPO company that provides accounts receivable management services can assist companies and will ensure a timely receipt.
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