If you’re in business, you’ve probably heard about accounts receivable turnover.
But you may be asking yourself what the heck is it? It sounds like one of those business buzzwords that can put your brain in an endless tizzy. But actually understanding accounts receivable turnover is much easier than you think.
In this post, we’ll cover everything you need to know about the topic: what it is, what you need to know about it, and why it’s important.
Without further delay, here’s what you need to know about accounts receivable turnover.
Why Is Knowing Your Accounts Receivable Turnover Critical to Your Business?
If you want to know how efficient your company is at collecting debts and managing credits, you need to calculate what’s known as the accounts receivable turnover ratio.
The way you figure it out is when you divide accounts receivable average into net credit sales. This calculation is usually done once a year.
Although the term can make your head go round in circles, understanding the idea and practicing it can improve your business big time. And it’s really not that difficult when you know the basics.
The Basics of Accounts Receivable Turnover
To start off with, accounts receivable turnover is a ratio. It’s calculated to determine how well your company collects payment on existing debts and customer credits.
You calculate it by determining your tracking period’s average accounts into your net credit earnings.
So what does this mean in layman’s terms? Your clients are paying what they owe in a timely fashion.
In this formula, cash sales don’t matter. Only credit sales are accounted for. You’re only concerned with credit effectiveness.
Higher collection numbers are equal to higher ratios and lower amounts of collections are equivalent to lower ratios.
Here’s an Example
For instance, suppose your company has a net credit sales of $200K for the year. Your receivables average are $50,000. For this calculation, your accounts receivable turnover ratio is 4 times ($200,000/$50,000 = 4).
This example indicates the ratio of four means your business collects receivables on a quarterly basis or cycles through the accounts receivable four times a year.
Your customer debts are typically being paid faster when your ratio is higher. This enables you to pay your business’s debts such as payroll and other debts since you have better cash flow.
When you have higher accounts receivable ratios, it also means that you’re paid your debts from customers, so you won’t have to write off bad debts.
When this happens, it’s a good sign of having a company that experiences better financial health.
Why Accounts Receivable Turnover Means
Aside from calculating the timeliness of payments received from your customers, the ratio helps you conclude how effectively your business manages your credit practices and policies in comparison with your customer’s debts.
What a High Ratio Tells You
This is what happens when your company has a high ratio:
- Your cash flow grows because more debts are paid
- You are extending credit to the best clients and don’t accrue more debt
- You see your collection practices are working
- You free up lines of credit for future investments and purchases since your customers pay off what they owe you in a timely fashion
What a Low Ratio Tells You
- You are being way too lenient
- You have inefficient collections policies
- If your customers are struggling financially, it’s likely they won’t buy from you in the future
- Your cash flow is suffering due to uncollected debts.
The Benefits of Tracking Accounts Receivables
When you trace your accounts receivables, you can see what adjustments you need to make in your policies to increase your bottom line.
You can also discover how your company collects and extends credit. And whether these practices and trends are moving your business in the right direction for growth every year.
Trying to acquire a loan? Financial lenders may view your accounts receivable turnover to decide if they want to approve a loan.
When looking at a company with a high accounts receivable turnover ratio compared to a business with a low turnover ratio, it’s obvious a higher ratio makes a better investment for a lender.
How to Use Your Accounts Receivable Turnover Ratio
When it comes to business planning and management, your accounts receivable turnover ratio can be critical to cash flow.
You can envision what your cash flow will be to plan future expenses by learning how fast clients pay what they owe now.
When you address collections problems to improve cash flow, it helps you to grow your company and gain additional investment opportunities.
Getting your ratio to a better place can help you acquire a business loan because many financial lenders use your accounts receivable ratio as collateral.
Improving your ratio can provide you with more collateral so lenders offer you better loan terms and interest rates.
One way to elevate your ratio is to design stricter collections policies. You can achieve this by offering incentives to clients who make timely payments and penalties for customers who pay late.
What if Your Accounts Receivable Turnover is Too High?
Of course, you want a high AR turnover ratio, but is there such a thing as too high? Surprisingly, the answer is yes.
When companies have AR turnovers that are too aggressive and lack flexibility, customers may take their business elsewhere.
These policies can damage your business and upset good customers. It’s possible that a good paying customer has an oversight. That’s why it’s important to know your customer’s payment history.
Always keep customer satisfaction in mind when it comes to a good paying customer.
The Bottom Line About Account Receivables Turnover
By now you have a better understanding of how your company’s accounts receivable turnover ratio affects your business.
It helps you measure and track the efficiency of your company. It opens up your business for investment opportunities and improving it can take your business to the next level.
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