Small business accounting involves a number of different terms and formulas that can help you monitor and stay in control of your company’s finances. One of these terms is accounts receivable turnover. Learning it is key is your business extends credit to customers, in other words, if you don’t get paid immediately after your clients contract a service or buy a product.
The construction industry is a clear example: usually, contractors don’t get paid in full until a Project is completely finished.
Essentially, accounts receivable turnover is a ratio that helps measure how efficient your business is at issuing credit to customers and collecting debts.
This might sound complex. Trust me, I thought the same thing. But, once you break it down, accounts receivable turnover is pretty easy to calculate and understand. After learning how to calculate it, this ratio will help you more effectively manage your business’ cash flow and finances.
What is Accounts Receivable Turnover?
In a nutshell, accounts receivable turnover refers to how often your business collects its accounts receivable throughout the year.
This ratio is typically calculated on a yearly basis and can be used to measure how efficient your business is at collecting debts from credit issued to customers.
More simply, it measures how often your business is able to turn your accounts receivable into cash during a year.
The Basics of Accounts Receivable Turnover
Like I said, your accounts receivable turnover ratio represents how efficient your business is at collecting debts from customers.
But what does this really mean?
Well, if you have a high accounts receivable turnover ratio, this tells you that your business is aggressive in collecting debts, has a lot of high-quality customers, and is probably conservative in lending credit to customers. This indicates that you are collecting your debts more often and your customers’ debts are being repaid more quickly.
On the other hand, if your ratio is low, it means that your business has not been effective in collecting debts. Probably your business’s credit policy is too lenient. If that’s the case, you can increase your working capital
by collecting outstanding debts from customers as soon as possible.
A higher ratio generally equates to better cash flow and the ability to pay back your own debts. Generally speaking, a higher accounts receivable turnover ratio indicates a financially healthier business.
If you find that your accounts receivable turnover ratio is too low, you may be able to improve it by adjusting your collections practices and collecting payments
Accounts Receivable Turnover Ratio Formula
Learning how to calculate your accounts receivable turnover ratio is incredibly useful. This ratio can help you more effectively manage your business’ finances and can help you identify where some of your cash flow problems may be coming from.
Fortunately, calculating this ratio is fairly easy. The formula is as follows:
Accounts Receivable Turnover Ratio = Net Credit Sales / Average Accounts Receivable
It’s important to use net credit sales instead of net sales since only credit sales create accounts receivable. Cash sales are left out because you can’t collect on money that you’ve already been paid.
Steps to Calculate Your Accounts Receivable Turnover
A formula is only good if you know how to use it. Fortunately, learning how to use this one is as easy as following a few simple steps.
1. Find Your Net Credit Sales
First, to use the formula above, you need to find your company’s net credit sales — that is, all sales made on credit rather than cash.
This figure should be on your balance statement or your business’ yearly income statement
. It should include all of your credit sales minus any allowances or returns.
2. Calculate Your Average Accounts Receivable
Next, you need to find your average accounts receivable.
Accounts receivable is any money that is owed to you by your customers. To calculate your average accounts receivable, you need to add the value of your accounts receivable from the start of the year to the value of your accounts receivable at the end of the year. Then, divide this number by two.
Your accounts receivable numbers from the beginning and end of the year should be on your business’ balance sheet.
3. Calculate Your Accounts Receivable Turnover Ratio
Once you have your net credit sales and average accounts receivable, you can plug these numbers into the formula outlined in the section above.
All you need to do is divide your net credit sales by your average accounts receivable. By doing this, you’ll be able to see how effective your small business is at collecting debt from customers.
Accounts Receivable Turnover: An Example
Everything’s easier with an example, so let’s take a look at how you would be able to use the accounts receivable turnover ratio formula in the real world.
Let’s say your business had a starting accounts receivable of $100,000 and ended the year with an accounts receivable of $225,000.
Step one would be to calculate your average accounts receivable as shown below:
(100,000 + 225,000) / 2 = $162,500
Next, say your business’ net credit sales are equal to $1.5 million. Now, using these numbers, you can calculate your accounts receivable turnover ratio using the following formula:
1,500,000 / 162,500 = 9.23
With these numbers, your company has an accounts receivable turnover ratio of 9.23. This means that your business is collecting your average accounts receivable about nine times per year. Is this high or low? It’s always helpful to compare your payment terms to what is average in your industry
To improve your accounts receivable turnover, you can request upfront payments from your clients or shorten their payment terms.
Staying on top of your accounts receivable is incredibly important.
Giving credit to high-quality customers and collecting debts quickly can help boost your business’ cash flow, increase your working capital, and help your business gain funds to pay back your debts.
On top of this, improving your accounts receivable ratio can even help you get a small business loan as many lenders use accounts receivable as collateral to secure the loan.
While calculating your accounts receivable turnover ratio might seem complicated at first, by following the steps outlined throughout this article, you can easily calculate yours and use it to see how you can improve your company’s financial wellbeing.