As a small business owner, you know about accounts receivable because they’re critical to your cash flow. But what about accounts receivable turnover?
If you’re unfamiliar with this phrase, you could be overlooking an important indicator of your business’ financial health — one that banks and investors may look at closely.
Here’s what you need to know about the accounts receivable turnover ratio and how it impacts your business.
What is Accounts Receivable Turnover?
The accounts receivable turnover (ART) calculation quantifies a business’ activity in the form of a ratio. It measures efficiency, and represents how quickly a business collects the money owed by customers.
Other names for the accounts receivable turnover ratio include:
- Receivable turnover ratio
- Accounts receivable turnover
- Debtors turnover ratio
Why Lenders and Investors Want to Know About Yours
When investors and financial institutions consider financing a business, they review the 5 C’s of Credit for Business, including capacity — how your business cash flow operates, and that includes ART.
Investors and financiers look at this ratio because it shows how efficiently your business collects on outstanding accounts. A business that is slow to collect outstanding accounts receivables could have cash flow struggles, resulting in difficulties meeting accounts payable (and debt) obligations.
Therefore, a poor ART could negatively impact investor opportunities and credit applications. And that, in turn, could stifle expansion plans and opportunities to grow a business.
How to Calculate Accounts Receivable Turnover
To calculate the accounts receivable turnover ratio, divide the net value of a company’s sales during a specified period by the average accounts receivable during the same period. Usually, the ART gets calculated annually, though it may also be calculated quarterly or even monthly to note any changes in trends.
It is easy to calculate the average receivables during a period. Simply take the receivables at the start date, and add the receivables at the end date. Then using the total, divide by two.
So the formula for ART looks like:
ART = Net Credit Sales/ Average Accounts Receivable
For example, say a company has $1.5 million in net credit sales for a period. It has accounts receivable of $100,000 at the start of the period, and $120,000 at the end. The ART is $1.5 million/ (($100,000 + $120,000)/2) = 13.64. This means that the company’s accounts receivable get collected or “turned over” 13.64 times during the year.
Bigger is Better
When it comes to the ART ratio, the bigger the number, the better. It’s easiest to see with an example.
With an annual ART of 13.64, we can calculate the average accounts receivable collection period as 26.76 days – (365/13.64). However, if the ART increases by just 1, to 14.64 ,the average accounts collection period gets reduced to 24.93 days. So a bigger ART means a more efficient, or shorter, collection period, which is good for cash flow.
What to Watch for When Comparing Account Receivable Turnover Ratios
If you’re reviewing or comparing ARTs, keep these three things in mind.
- Some companies use “total sales” instead of “net sales” in the ART calculation. And this may result in a higher number because it includes cash sales, which of course shortens the collection period because collection is immediate.
- The accounts receivable balances used at the start date and the end date of the period show the balances for two specific points in time. And they may differ significantly from the average accounts receivable balance for the period. That’s why it’s also considered acceptable to use an alternate method of calculating the average accounts receivable balance for the ART ratio, such as taking an average of 12 months of ending accounts receivable balances.
- Sometimes, a lower ART may result from areas of a business other than the credit and collections policies, such as if there’s a product or service quality issue resulting in customers who refuse to pay.
5 Ways to Increase Your Business’ Accounts Receivable Turnover
If you’re looking to boost your business’s ART, here are five methods to consider:
- Screen customers more carefully before working out credit terms. Researching a company and its previous credit history can help uncover poor payment activity.
- Shorten the time between product/service delivery and billing. The sooner the customer gets the bill, the sooner they can pay.
- Offer a discount as an incentive to customers who pay immediately or within a shorter period.
- Send reminder notices out sooner, such as right at the thirty-day mark instead of waiting until the bill is 40 or 45 days past due.
- Introduce a more aggressive late payment and collections policy. This may include taking action on late payments sooner, and introducing a small late payment penalty for overdue accounts.1
Understanding what ART represents and how to increase it not can help business owners make wiser decisions that may improve cash flow. This in turn could have a positive impact on your business’ overall financial health.
- “A Company’s Vital Signs—Accounts Receivable” Financial Accounting, University of Minnesota Press.