How To Calculate Accounts Receivable Turnover Ratio

Most businesses extend credit to their customers, even if they don’t realize they’re doing so. For example, if you send invoices to your customers and accept payments on a net-30 basis, you’re essentially making sales on credit with clear payment terms.

Of course, some customers will make early or on-time payments, and others will make late payments. Some may not pay at all, resulting in bad debts. That’s why you should keep an eye on the money parties owe you and the payments you receive, which is known as the accounts receivable process.

It’s also important to keep track of how efficient your company is at turning its accounts receivable balance into cash. Otherwise, you risk making uninformed financial decisions that could have a detrimental impact on your company.

That’s where the accounts receivable turnover ratio, one of the most important financial ratios in accrual accounting, comes in. It helps you form a better understanding of how efficient your company is at turning outstanding debts into cash through timely collections.

Definition And Importance Of Accounts Receivable Turnover Ratio

The accounts receivable turnover ratio is a financial ratio that shows how many times a company collects its accounts receivable balance over a year or another accounting period. It’s essentially a gauge of how well a company manages the money owed to it by its customers.

A good accounts receivable turnover ratio is generally 7.8 or above — though your industry average may be higher or lower. Lower ratios suggest there may be a more efficient way to manage debts owed to your company.

There are also other uses for the accounts receivable turnover ratio. For instance, you can use it to create financial models and predict revenues for future accounting periods. In fact, financial teams commonly use it as they generate financial statements like balance sheets.

It’s important to note that the accounts receivable turnover ratio differs from the asset turnover ratio, which measures a company’s ability to turn current assets into revenue over a period of time. After all, these two ratios measure two very different metrics. So, using them interchangeably would likely lead to inconsistencies in your accounting.

How To Calculate Accounts Receivable Turnover Ratio

The accounts receivable turnover ratio formula is as follows:

(Gross Credit Sales - Starting Accounts Receivable) / ((Accounts Receivable Starting Balance + Account Receivable Ending Balance)/2) = Accounts Receivables Turnover Ratio

Keep in mind that this ratio doesn’t include cash sales, as sales completed on a cash basis don’t add to the accounts receivable balance. The calculation only includes credit sales.

Nonetheless, let’s say your business generated $200,000 in gross credit sales. Your starting accounts receivable were $20,000 and ending accounts receivable were $30,000. Here’s what the formula would look like:

($200,000 - $20,000) / (($20,000 + $30,000)/2) = 7.2

Based on this example, your company turns its accounts receivable into cash 7.2 times per year. You can use this data to form a better understanding of your business income. If you’re not confident doing your accounts receivable turnover ratio calculations, consider one of the many free online accounts receivable turnover ratio calculators.

Tips For Improving Accounts Receivable Turnover Ratio

As a business owner or executive, you should strive for a better average accounts receivable turnover ratio. The more you improve your ratio, the more efficient your company is at turning credit into revenue and profitability.

Here are a few tips on how to boost your accounts receivable turnover ratio:

1. Enhance Your Invoice Management

If you can’t keep clear financial records, you won’t be able to produce reliable data in your financial calculations — leading to potentially false and misleading financial forecasts and reporting. So, the first place to start when it comes to improving your ratio over time is to enhance your invoice management process.

If you’re still managing invoices manually using spreadsheets, it’s time to upgrade your process. Consider taking advantage of improved bookkeeping technologies like accounting and bookkeeping software to ensure you don’t have invoices falling through the cracks. These technologies automatically track your spending and income and provide reports to make optimization opportunities more visual.

Moreover, when you take advantage of today’s cutting-edge technology, you cut human error, leading to more accurate financial record-keeping.

2. Implement Effective Credit Policies

A business’s policies are what make that business consistent. Your employees will follow your company’s policies as they accept payments and spend money. And your accounting teams will need clear guidelines to help ensure that all data is uniform and easy to digest.

Your credit policies should include:

• Timeframes: You should have a policy with a clear timeframe for how long you extend the credit. This may be 30, 60, or 90 days, but it must be the same across the board.
• Payment Terms: Be sure your customers know how, when, and where you accept payments for the products or services you provide.
• Default policy: Have a clear policy for how you handle defaults. For example, you may charge a late fee for any invoices paid more than 10 days late.  
• Collections policy: Finally, create a collections policy to outline how you’ll collect money when accounts are past due.  

3. Use Accounting Software For Efficiency

If you’re still using a pen and pad to keep track of your company’s finances, it’s time to upgrade. The manual process is far more time-consuming than it has to be and opens the door to human error.

Today’s best accounting software solutions implement tools like automation to make it easy to track and manage invoices, implement policies, and more. Moreover, the best software solutions typically use artificial intelligence (AI), which may help you pinpoint opportunities to optimize your invoicing and collections process by analyzing large amounts of data that humans simply wouldn’t have the time or capacity to analyze.

4. Build Stronger Customer Relationships

Customers are more likely to pay their bills if they’ve had a positive interaction with your business. So, by simply focusing on your customers and building stronger relationships with them, you may improve your accounts receivable turnover ratio.

Here are a few ideas for improving your customers’ experiences:

• Send thank you messages when you sign new customers up for your product or service. These messages validate their decision to do business with you and help to form the basis for a strong relationship.
• Ask how you can improve your services, making it clear that the customer is at the center of your operations.
• Offer loyalty programs and well wishes on holidays and birthdays, showing you value and take care of your customers individually.

5. Assess Customer Creditworthiness

It may not be wise to extend credit to every customer you have. After all, some customers will be more likely to pay you on time than others. As such, assessing a customer’s creditworthiness might be wise before you offer up credit.

If you assess the customer’s creditworthiness only to find they have a history of late and missed payments, it’s likely best to accept only cash business from that customer.

6. Adjust Credit Terms Based On Risk Analysis

If you’re uncomfortable turning down customers with poor credit scores and overall applications, you can adjust your credit terms based on risk. For example, someone with a strong credit score and overall application may qualify for 100% short-term credit.

However, you may require customers with fair or poor credit scores to pay for 50% of your product or service upfront. This way, if they don’t pay their bill in the long run, you’ll likely recuperate the cost of the product or service you provided through the 50% upfront payment.

7. Streamline Dispute Management Processes

Disputes can have a significant impact on your accounts receivable turnover ratio. That’s especially the case if your dispute management process is slow. After all, customers aren’t likely to pay your invoice if they have a dispute against your company or services.

Create a process for how you’ll manage disputes to reduce customer friction and speed everything up. For example, set a specific amount of time your employees have to address and settle disputes and give them tools (like the ability to offer partial refunds) to manage those disputes. In doing so, you’ll likely be able to settle with your customers faster, resulting in a higher accounts receivable turnover ratio.

8. Practice Proactive Follow-Up On Overdue Accounts

Some customers will pay late; that’s just part of extending credit to others. However, you can motivate these customers to speed up payments by sending follow-ups.

As soon as the due date on an account passes, you should reach out to your customer. But first, create a plan for how often you’ll follow up with your customers. For example, you can email them once a week after their due date to remind them of their past-due accounts. The more proactive you are with your follow-up efforts, the more successful they are likely to be.

9. Educate Your Team On Accounts Receivable Best Practices

Everyone on your team needs to be aware of accounts receivable best practices and willing to follow them for you to have the best accounts receivable turnover ratio possible. When your team follows your policies and best practices, you’re more likely to collect money more efficiently. So, keep your team updated on your policies, procedures, and best practices.

10. Encourage A Collaborative Approach To Receivables Management

As you create accounts receivable policies and best practices, involve your entire team in the process. Consider and incorporate your employees’ ideas. It will give you immediate access to different perspectives and fresh and innovative insights that could help improve your processes.

Moreover, employees who feel heard make up a team with higher morale and productivity.

11. Conduct Regular Accounts Receivable Audits

Accounts receivable audits help you keep everything on track. They aid you in checking whether everyone is following the set policies and procedures and collecting valuable data.

For instance, you can better predict and optimize money collections by analyzing your customers’ past and current transactions and payments. Ultimately, this will lead to optimizing your accounts receivable turnover ratio in the long run.

Comb through your accounts receivable process and documents at least quarterly on an accounting period to ensure things are running smoothly.

Maximize Financial Health With Effective Receivables Management

Your accounts receivable turnover ratio is much more than a simple number. It shows you just how effective you and your team are at turning extended credit into revenue, and it forms the basis for financial predictions for the future.

If you want to improve your company’s financial health, your accounts receivable turnover ratio is a great place to start. Use the tips above to make your accounts receivable department as efficient as possible.

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