Receivable Turnover RatioFormula, Examples and How to Calculate!
Continuous improvement of your business and its processes is essential for its continued existence and eventual success.
It shows promise to your stakeholders that you care about your business enough to have it evolve as it continues to operate.
One of the processes that you can improve upon when it comes to your business is the process of how it deals with credit extended to customers – a.k.a accounts receivable.
Accounts receivable is linked with credit sales or sales on credit.
Oftentimes, businesses offer sales on credit in an effort to increase their total sales.
By offering sales on credit, businesses can accommodate customers who don’t always have cash readily available on hand.
This increases the potential customer base that the businesses can reach.
There are concerns when it comes to credit sales though.
One, when a business makes a credit sale, it won’t be receiving cash at the time of sale but rather at a later time.
This will certainly affect the business’s liquidity.
Another, there is the risk of not being able to collect any cash on the sale at all.
Businesses must do what they can to avoid such a thing from happening.
Having strong credit and collection policies help a business in dealing with its credit sales and the corresponding accounts receivable.
Also, there are many tools that can help a business in managing its accounts receivable such as financial ratios.
One such ratio is the Receivable Turnover Ratio.
In this article, we will learn about the Receivable Turnover Ratio, what it tells you about your business, and how to compute for it.
With proper knowledge about how it works, you can design or improve your current policies and practices to ensure that your business collects payments on time.
It can also help your business in managing your business’s credit effectively.
What is Receivable Turnover Ratio?
One of the efficiency ratios, the Receivable Turnover Ratio is a metric that measures how often a business’s accounts receivable is collected (on average) over a given period.
It is also known as the Debtor’s Turnover Ratio or the Accounts Receivable Turnover Ratio.
It gives us an idea of how effective and efficient the business is in collecting its receivables.
This ratio can be computed on a monthly, quarterly, or yearly basis.
In essence, accounts receivable are loans extended to customers – except that they receive products instead of cash, and that there’s no interest.
So they’re worse than actual loans, but the exchange is that there are more sales.
Accounts receivable often have terms of 30 or 60 days, though there are some businesses within certain industries that can extend the term to even more than a year.
Top management often gives more importance to sales and profit margins, and it shows.
In an income statement, what is often shown are the sales, be it cash sales or credit sales, and other income items.
Less importance is given to the collection of accounts receivable.
This is why some businesses report high sales figures yet still face liquidity issues.
Credit management (or management of accounts receivable) and liquidity go hand in hand.
If a company has a high collection rate, then it follows that it will have great liquidity.
With the receivable turnover ratio, we can get a quantitative measure of a company’s ability to collect its accounts receivable.
How to compute Receivable Turnover Ratio
Computing a business’s receivable turnover ratio is pretty straightforward once you have the required data.
You only need to divide the net credit sales by the average accounts receivable. Put into formula form, it will be:
Receivable Turnover Ratio = Net Credit Sales ÷ Average Accounts Receivable
Net Credit Sales – refer to sales on credit or sales where cash payment is collected within a certain period. It can be computed by subtracting the sales discounts, returns, and allowances from the gross credit sales. If possible, identify the sales discounts, returns, allowances that are attributable to credit sales
Average Accounts Receivable – refers to the average of the beginning and ending balances of accounts receivable. It can be computed by adding the sum of the aforementioned balances and dividing the resulting figure by two. If there are significant fluctuations between the beginning and ending balances, the weighted average can be used instead.
Gathering the data required for the computation of the receivable turnover ratio is probably the hardest part of it.
While the beginning and ending balances of a business can readily be found on its balance sheet, the data on credit sales isn’t always available.
Unless a company’s accounting policy, practice, or system separately accounts for credit sales, more often than not, only the total sales will be accounted for (whether it’d cash sales or credit sales).
That’s why in some cases, the net sales figure is used instead of net credit sales.
Example of Receivable Turnover Ratio
To further understand the receivable turnover ratio, let’s have some exercises.
Company VC has the following data in regards to its credit sales:
|Accounts Receivable, January 1, 2020||$400,000.00|
|Accounts Receivable, December 31, 2020||$369,000.00|
Company VC does not have any sales returns, sales discounts, or sales allowances.
Company VC’s top management wants to know how often it collects on its receivables.
To answer their query, we compute for company VC’s receivable turnover ratio:
Receivable Turnover Ratio = Net Credit Sales ÷ Average Accounts Receivable
Receivable Turnover Ratio = $5,000,000 ÷ ($400,000 + $369,000)/2
Receivable Turnover Ratio = $5,000,000 ÷ ($769,000)/2
Receivable Turnover Ratio = $5,000,00 ÷ $384,500
Receivable Turnover Ratio = 13.0039 or 13
As per computation, company VC’s receivable turnover ratio is 13.
This means that company VC was able to convert its receivables to cash 13 times during the year 2020.
The top management also wants to know how long it takes for the company to collect its receivables (on average).
To answer this query, we will have to acquire company VC’s average collection period which can be computed by dividing the number of days in a period by the receivable turnover ratio (in this case, the number of days in a period is 365)
Average collection Period = Number of Days in Period ÷ Receivable Turnover Ratio
Average collection Period = 365 ÷ 13
Average collection Period = 28.07
As per computation, the average collection period is 28.07.
This means that, on average, it takes 28.07 or 28 days for company VC to collect its accounts receivable.
Now whether this is a good figure or not depends on company VC’s credit policy or the industry it belongs in.
If its credit policy states that the maximum credit term for credit sales is 30 days, then it is a good figure.
It means that they’re ahead in terms of collection.
However, if its credit policy states that the maximum credit term for credit sales is 20 days instead, then they are behind by at least 8 days in their collection.
High or Low Receivable Turnover Ratio – which is better?
In general, a high receivable turnover ratio is favorable.
It could mean that the business is employing strong credit and collection practices.
Having a high receivable turnover ratio means that the business is able to collect its receivables more often compared to a business that has a low receivable ratio.
It could also mean that the business is only granting credit to customers that have the capacity to pay, and always pay on time.
However, a business that has a receivable turnover ratio could also mean that it’s conservative in offering credit sales to customers.
By being too conservative, the business cannot reach out to customers that prefer more flexible or loose credit terms.
As such, that business might be losing out on some sales opportunities.
Being over aggressive with its collection may also turn off its current customers.
That’s not to say that having a low receivable turnover ratio is the answer though.
A business that has a low receivable turnover ratio, most often than not, indicates that it is not doing a great job in managing its receivables.
It could be that the business does not have a strong credit policy in place, or that its collection practices are neither effective nor efficient.
The business is probably liberally extending credit to customers regardless of their capacity to pay.
This presents a risk of extending credit to customers who won’t be able to pay.
Having a low receivable turnover ratio means that the business takes longer to collect on its receivables.
This negatively affects the business’s liquidity and can cause issues.
Finding the balance between a reasonably high receivable turnover ratio and high credit sales will more than likely lead to a business’s success.
It might be a good idea to refer to your competitor’s receivable turnover ratio or the industry average to get a grasp of what is a competitive receivable turnover ratio for your business.
Here is a link that shows data on the receivable turnover ratio industry average for Q3 2021: www.csimarket.com
Ways to improve your business’s receivable turnover ratio
If your business’s receivable turnover ratio is too low, don’t fret. There are still ways you can turn it around. Here are some ways in which you can improve your receivable turnover ratio:
Be accurate and timely in billing your customers
If the customer does not know or remember his/her dues, chances are, s/he won’t be able to pay you on time.
That is why you must send invoices/billing statements to your customer regularly so that they are constantly reminded.
Also, you have to make sure that the billing statements are accurate and are sent to the correct customers.
A customer might refuse to pay you because of an incorrect/inaccurate billing statement.
It might be worth it to assign an employee this role.
There’s also accounting software that can help in automating the billing process.
Offer your customers various payment options
Some customers may prefer to pay in person.
Some may prefer to pay online.
Some may prefer to have their payment personally collected by a collecting officer.
Offering several modes of payment to your customers makes it easier and comfortable for them to make payments.
Especially now that we’re in an age where debit cards and cards are widely used, and where some businesses accept digital coins as payment.
Offering a payment option that your competitors don’t offer will give your business a competitive edge.
Always state payment terms (and make them clear and easy to understand)
A customer won’t pay if s/he doesn’t know what it is s/he is paying for.
Make sure that your contracts, invoices/billing statements, and communications letters state your business’s policy for credit sales.
State how long the credit term is (e.g. 20 days, 30 days, 45 days, etc.).
You may also state the penalties for late payment if there are any.
By making your payment terms clear, your customers would be well informed and are more likely to pay on time.
Regularly remind your customers about their dues (but do it courteously)
While it is ideal for customers to be proactive in paying on time, that is not always the case in real life.
Most customers will have to be regularly reminded of their dues.
Be proactive in reminding your customers, but don’t overdo it.
Don’t be too aggressive or annoying.
Offer discounts for cash and early payments
You may want to consider giving incentives to customers who pay cash at the time of sale or to those who pay ahead of time.
This encourages your customers to pay much earlier as it means that they’ll be paying you less compared to when then they pay at the end of the credit term.
It doesn’t have to be always though. You can make it seasonal or promotional (e.g. whenever a new product arrives, available only for the first 500 customers, etc.).
It might cost you a portion of your sales, but you’ll be receiving cash much earlier.
Limitations of the Receivable Turnover Ratio
The receivable turnover ratio, just like any efficiency ratio, has its own set of limitations.
While it can tell you a lot about the business’s ability to convert receivables into cash, there are still some aspects which it can’t capture.
For example, since it’s an average, it does not capture the variation of accounts receivable throughout the year.
There are businesses in which credit sales and AR collection vary wildly due to seasonal factors.
This can be somewhat remedied by using the weighted average of accounts receivable instead of just the average.
Also, the receivable turnover ratio does not capture the individual aging of receivables.
You may want to rely on the accounts receivable aging report for that instead.
It shows how much time has passed from the date the credit sale was made to the date of the report.
If your business doesn’t have one already, it is recommended that you start preparing it now.
Another limitation of the receivable turnover ratio is more on the business itself.
Some businesses don’t have the date for credit sales readily available.
This is why they use net sales instead of net credit sales as the numerator for the receivable turnover ratio formula.
As a result, the resulting figure tends to be inflated unless all of the business’s sales are credit sales.
Lastly, what is considered “good” or “bad” receivable turnover ratio greatly depends on the industry the business belongs to, and the business itself.
Some businesses within certain industries are expected to have low receivable turnover ratios due to the nature of their business.
The reverse can be true too in that some business within certain industries are expected to have high receivable turnover ratios.
When comparing your business’s receivable turnover ratio to other businesses, make sure that they are within the same industry.
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CSIMarket.com "Receivable Turnover Ratio Screening as of Q3 of 2021" Page 1 . November 15, 2021
Southern Utah University "Balance sheet ratios" Page 1 . November 15, 2021
DePaul University "Accounts receivable turnover Ratio" Page 1 . November 15, 2021