In this blog, you’ll learn:
- What your accounts receivable turnover ratio means
- How to calculate it
- What ratio you should aim for, and
- What you can do to improve your ratio
The ability to efficiently collect debts is vital to any business that offers credit terms. When customers don’t pay on time, this can quickly lead to cash flow problems with significant downstream impacts. Often a supplier can’t release inventory until a payment has been received or make more sales with a customer until their credit has been replenished
Collections challenges are often a result of inefficiencies in the accounts receivable (AR) process. Accounts receivable turnover ratio is an important metric for understanding and determining the effectiveness of your collections efforts.
What is “accounts receivable turnover ratio”?
Accounts receivable turnover ratio is a measure of how good your company is at collecting debts.
It tells you the number of times during a given period (e.g., a month, quarter, or year) the company collected its average accounts receivable. A higher number is preferable as it means you’re collecting your debts more efficiently. But, you should always compare your ratio to the average for your industry to see how your company is performing in the context of your business.
Companies need to be smart about who they extend credit to. Accounts receivable turnover ratio gives them quick insight into how well they’re doing so.
How to calculate accounts receivable turnover ratio
The basic formula for determining your accounts receivable turnover ratio looks like this:
- Net Credit Sales / Average Accounts Receivable = Accounts Receivable Turnover Ratio
First, you’ll need to calculate your net credit sales. To do this, take your total sales made on credit and subtract any returns and sales allowances.
- Sales on Credit - Returns and Sales Allowances = Net Credit Sales
Next, you’ll need to calculate your average accounts receivable. To do this, take the sum of your starting and ending receivables over a given period and divide this by two.
- (Starting Receivables + Ending Receivables) / 2 = Average Accounts Receivable
Finally, divide your net credit sales by your average accounts receivable for the same period. This will give you your accounts receivable turnover ratio.
Accounts receivable turnover ratio example
Here’s an example of how you might use accounts receivable turnover ratio to assess the effectiveness of your collections efforts.
Let’s imagine your annual credit sales are $90 million ($100 million - $10 million in returns). Your starting and ending receivables are $10 million and $14 million, resulting in an average accounts receivable balance of $12 million. This means your turnover rate is 7.5. The math looks like this:
- $100 million sales on credit - $10 million returns = $90 million net annual credit sales
- ($10 million starting + $14 million ending receivables) / 2 = $12 million average accounts receivable
- $90 million / $12 million = 7.5 accounts receivable turnover ratio
A turnover ratio of 7.5 would mean that within this period (a year in this instance), you collected your average receivables 7.5 times. This means that on average, it takes your customers about 48 days to pay on credit (365 / 7.5). 45 days and below is what’s considered ideal for your average collection period. But because collections can vary significantly by industry, it’s worth looking at your turnover ratio in the context of your industry.
For instance, if the average accounts receivable turnover ratio for your industry were 5, then with your ratio of 7.5, you would be collecting debts at a better rate than the industry average. But if your industry average were closer to 10, then this could mean there are issues in your AR processes worth examining.
According to a survey conducted by CSIMarket, some of the industries with the best ratios in Q3 of 2021 were energy (96.5), healthcare (21.62), retail (15.29), and technology (10.79). At the other end of the list, the worst-performing industries were conglomerates (6.27), services (2.40), and utilities (1.74).
What does a good AR turnover ratio mean?
Generally a high AR turnover ratio is ideal, as it implies the company is collecting its debts efficiently. A low number could mean the company is not very discerning with who it extends credit to or that there are barriers impeding the collections process.
For instance, sending out paper invoicing practices could be delaying when customers receive their invoices. Relying on disjointed communication methods like phone calls and emails to find out the status of a payment could be preventing AR staff from making headway in collections.
By automating your collections workflows with AR automation software, you can better your chances of getting paid on time, substantially improving your accounts receivable turnover ratio.
How to improve your accounts receivable turnover ratio with AR automation
Here are three ways that an AR automation solution can help improve your accounts receivable turnover ratio:
1. Automated invoice delivery
Slow collections could be a result of inefficient invoicing practices. The time it takes your team to prepare and send out invoices prolongs the time it will take for that invoice to get to your customer and for them to pay it.
With an AR automation solution that integrates directly with your enterprise resource planning (ERP) system, you can create invoices as you normally would in your primary accounting system and deliver them to your customers automatically.
A platform like Versapay that supports omni-channel invoicing lets your customers access their billing details in whichever format suits them best—be it email, customer portal, EDI, accounts payable portal, or even paper. Delivering invoices in a more convenient format also increases customers’ likelihood to pay you faster.
2. Reminders sent before a bill is due
With AR automation, you can prompt customers to pay as a payment date approaches.
By proactively notifying your customers of payment with personalized communications, you improve your chances of getting paid before receivables become overdue. With Versapay, you can deliver custom notifications automatically and direct customers to pay online, eliminating much of your team’s need for collections calls.
3. Faster dispute resolution
Common contributors to late payments are invoicing errors and payment disputes. If customers have a difficult time getting a hold of your AR team to correct billing errors or address issues with their order prior to payment, this will make it difficult for you to capture revenue quickly.
Versapay allows your customers to raise any issues by leaving a comment directly on their invoice. This allows members of your team to address concerns in real time. In providing direct access to their complete account information and the ability to make payments online, you give customers the opportunity to self-serve and significantly reduce inquiries coming into your AR department.
Interested in seeing AR automation in action? Book a Versapay demo today and discuss your needs with one of our AR automation experts.
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