If you’ve ever felt the weight of chasing down payments, deciphering financial jargon, or spending endless hours manually updating sheets, you’re not alone. Ideally, every customer you sell to will end up paying at some point – but if you’ve been in business long enough you realize this isn’t always the case. By differentiating between gross and net AR, businesses can brace for potential losses from non-paying customers.

The accounts receivable turnover ratio is an efficiency ratio and is an indicator of a company’s financial and operational performance. A high ratio is desirable, as it indicates that the company’s collection of accounts receivable is frequent and efficient. A high accounts receivable turnover also indicates that the company enjoys a high-quality customer base that is able to pay their debts quickly. Also, a high ratio can suggest that the company follows a conservative credit policy such as net-20-days or even a net-10-days policy. The accounts receivable turnover ratio measures the number of times over a given period that a company collects its average accounts receivable.

The accounts receivable turnover ratio tells a company how efficiently its collection process is. This is important because it directly correlates to how much cash a company may have on hand in addition to how much cash it may expect to receive in the short-term. By failing to monitor or manage its collection process, a company may fail to receive payments or be inefficiently overseeing its cash management process. The numerator of the accounts receivable turnover ratio is net credit sales, the amount of revenue earned by a company paid via credit. This figure include cash sales as cash sales do not incur accounts receivable activity.

Accounts Receivable Turnover Ratio Template

To calculate AR turnover, you need to start by finding average accounts receivable. A low accounts receivable turnover ratio, on the other hand, often indicates that the credit policies of the business are too loose. For example, you may allow a longer period of time for clients to pay or not enforce late fees once your deadline to pay has passed.

  • For example, the banking sector relies heavily on receivables because of the loans and mortgages that it offers to consumers.
  • Also, a high ratio can suggest that the company follows a conservative credit policy such as net-20-days or even a net-10-days policy.
  • Furthermore, because this ratio considers the average performance across your entire customer base, it lacks the precision needed to pinpoint specific accounts at risk of default.

The average collection period is an accounting metric used to represent the average number of days between a credit sale date and the date when the purchaser remits payment. A company’s average collection period is indicative of the effectiveness of its AR management practices. Businesses must be able to manage their average collection period to operate smoothly. The A/R turnover ratio is part of a larger family of financial ratios known as asset management ratios, or activity ratios. These ratios measure how efficiently a company is managing its assets to generate cash flows for the business. The receivables turnover ratio shows us that Alpha Lumber collected its receivables 11.43 times during 2021.

Your efficiency ratio is the average number of times that your company collects accounts receivable throughout the year. An average accounts receivable turnover ratio of 12 means that your company collects its receivables 12 times per year or every 30 days. This type of evaluation, in business accounting, is known as accounts receivables turnover. You can calculate it by dividing your net credit sales and the average accounts receivable balance.

With certain types of business, such as any that operate primarily with cash sales, high receivables turnover ratio may not necessarily point to business health. You may simply end up with a high ratio because the small percentage of your customers you extend credit to are good at paying on time. To identify your average collection period, divide the number of days in your accounting cycle by the receivables turnover ratio. Calculating your accounts receivable turnover ratio can help you avoid negative cash flow surprises.

What Is an Average Collection Period?

Track and compare these results to identify any trends or patterns that may develop. Some companies use total sales instead of net sales when calculating their turnover ratio. This inaccuracy skews results as it makes a company’s calculation look higher. When evaluating an externally-calculated ratio, ensure you understand how the ratio was calculated. The receivables turnover ratio is just like any other metric that tries to gauge the efficiency of a business in that it comes with certain limitations that are important for any investor to consider. It measures the value of a company’s sales or revenues relative to the value of its assets and indicates how efficiently a company uses its assets to generate revenue.

How to Calculate Net Accounts Receivable

The average collection period may also be used to compare one company with its competitors, either individually or grouped together. Similar companies should produce similar financial metrics, so the average collection period can be used as a benchmark against another company’s performance. Assuming that this ratio is low for the lumber industry, Alpha Lumber’s leaders should review the company’s credit policies and consider if it’s time to implement more conservative payment requirements. This might include shortening payment terms or even adding fees for late payments.

How to calculate average accounts receivable

If you have a rapidly growing business, then using the average receivable balance for the last 12 months will understate the amount of receivables to be expected on a go-forward basis. Conversely, the average receivable reported for a declining business would be overstated. In these cases, it would be more accurate to average the accounts receivable over just the last three months. It’s useful to compare a company’s ratio to that of its competitors or similar companies within its industry.

As you can see in the example below, the accounts receivable balance is driven by the assumption that revenue takes approximately 10 days to be received (on average). Therefore, revenue in each period is multiplied by 10 and divided by the number of days in the period to get the AR balance. On the other hand, a low accounts receivable turnover ratio suggests that the company’s collection double entry definition process is poor. This can be due to the company extending credit terms to non-creditworthy customers who are experiencing financial difficulties. Accounts receivable is a business term used to describe money that entities owe to a company when they purchase goods and/or services. AR is listed on corporations’ balance sheets as current assets and measures their liquidity.

Another reason you may have a high receivables turnover is that you have strict or conservative credit policies, meaning you’re careful about who you offer credit to. When you have specific restrictions for those you offer credit to, it helps you avoid customers who aren’t credit-worthy and are more likely to put off paying their debts. This metric provides the average number of days it takes to collect an outstanding invoice after a sale has been made. It helps you forecast how much cash flow you can expect in the future based on sales you made today. Accounts receivable KPI form the backbone of an effective AR monitoring system.

The average receivables is the average amount your customers owed to you throughout the period. Work this out by adding the starting and closing receivables at the beginning and end of the period and divide this by two. A low ratio may also indicate that your business has subpar collection processes. On the other hand, it could also be that your collection staff members are not receiving the training they need or are not assertive enough when following up on unpaid invoices. Use this formula to calculate the receivables turnover ratio for your business at least once every quarter.

Liberal credit policies may initially be attractive because they seem like they’ll help establish goodwill and attract new customers. Although that may be true, nothing negates positive feelings like having to hassle someone over unpaid bills. When making comparisons, it’s ideal to look at businesses that have similar business models. Once again, the results can be skewed if there are glaring differences between the companies being compared. With InvoiceSherpa, you get peace of mind knowing that your invoicing is on auto-pilot. So, take the leap towards streamlined, stress-free AR management and learn how to automate accounts receivable with our software today.