Many service-based businesses do not get paid immediately after serving their customers. Instead, they send invoices to their customers that contain the agreed-upon due date for the full payment. This business model has worked for generations but doesn’t always achieve the expected result. Common problems include customers failing to pay on time and businesses extending too much credit for their financial needs.
Like countless other financial issues, examining data can prevent your accounts receivable policies from seriously hurting your business. You just have to know which numbers to look at and which actions to take in response.
Luckily, just one calculation can answer that first question: the accounts receivable turnover formula. This simple formula will reveal your accounts receivable ratio, which denotes the effectiveness of your accounts receivable policies. For businesses like wholesalers, auto shops, land surveyors, and even doctor’s offices, improving their accounts receivable ratio directly impacts their cash flow and profitability.
So, let’s explain how to calculate your accounts receivable turnover ratio, why it’s so important, and how to correct different accounts receivable-related issues.
What Is Your Accounts Receivable Turnover Ratio?
The accounts receivable turnover ratio assesses your ability to collect debt with your current credit policy. To find your business’s accounts receivable turnover ratio, divide your net credit sales by your average accounts receivable.
In most cases, you should strive for the highest possible ratio. This shows that your business collects debt efficiently and therefore proves the effectiveness of your current credit policy. Think of it as reaching perfection in three essential areas: the amount of debt you take on, the amount of credit you extend, and the rate in which you collect debt. If you collect smaller portions of the money owed to you, on the other hand, your ratio will decrease.
Businesses typically measure their accounts receivable turnover on an annual basis, but that might change as more and more companies increase the role of data in their general strategies.
Accounts Receivable Turnover: Net Credit Sales
As you can see, the accounts receivable turnover formula requires just two figures: net credit sales and average accounts receivable. The first figure refers to your total sales that were made on credit for the year. Cash transactions do not count (they don’t create receivables), and you must also subtract any returns or allowances. You can find your net credit sales on your income statement or balance sheet, so there’s really no need to do any calculations.
Accounts Receivable Turnover: Average Accounts Receivable
The second figure in the accounts receivable turnover formula refers to the amount of money your customers owe you (on average). You need just two calculations to find your average accounts receivable. First, take your accounts receivable at the beginning and end of the year and add them together. Then, divide your answer by two. Once again, while it always helps to know how to calculate important figures, you can also find your average accounts receivable on your balance sheet.
Accounts Receivable Turnover Example
In this example, your company earned $250,000 in annual net credit sales, and your average accounts receivable comes out to $50,000. This would give you an accounts receivable turnover ratio of 5.
$250,000/$50,000 = 5
Your answer represents the rate in which your business collected your average receivables throughout the year. Hence, your business collected your average accounts receivable five times per year and therefore reached your average accounts receivable (the average amount owed by your customers) five times.
What Your Accounts Receivable Turnover Ratio Means
The higher your accounts receivable turnover ratio, the faster your business collects the average amount of debt it takes on. To clarify, businesses with high ratios collect their customers’ debts quickly. This also suggests that the business likely never has to write off debts and always gets paid for its services in full, even if the payment comes in later than the requested due date.
To understand the importance of getting paid on time, think of your services like retail inventory. When inventory sits on your shelves for long periods of time, your businesses loses money. The lack of sales means you have less money to plug back into your business. In addition to covering business expenses, some of this money could go towards expanding your product line or building your savings account, which would increase your likelihood of approval for business loans.
Let’s say you eventually sell the item. You still wouldn’t earn as much money as you would have if the item had been sold shortly after you purchased it. In other words, the item becomes less profitable.
Businesses with good profit margins keep their spending in proportion to what they earn. Unsold inventory, however, forces you to continue spending money (inventory, payroll, operations, etc.) while earning less. This decreases your profitability and thus makes it more difficult to obtain financing or grow your business in general.
Takeaways: High Accounts Receivable Turnover Ratio
Several components contribute to your accounts receivable turnover ratio. First, you have the character of your customers. The size or current success of certain businesses doesn’t make them any more likely to pay on time. In fact, big businesses often fail to pay on time due to their massive list of customers or the amount of people an invoice must go through before it gets paid. Smaller businesses have their share of problems too, like rough patches or emergency expenses that disrupt their cash flow.
In summary, timely payments tend to stem from the combination of responsible management tactics and the prioritization of long-term partnerships. Extending too much credit to customers with issues in either area would probably just delay your payments even further.
If you truly believe your customers have strong character, you might want to re-consider your collection methods. The popularity of automated invoicing systems, for example, has proven that simply sending more than one invoice per month dramatically increases the likelihood of timely payments. Some businesses have found similar success with sending invoices at different intervals (the beginning, middle, or end of the month) depending on the dates of the customer’s previous payments.
Other ideas include offering discounts for customers who pay on time, or only offering 30-day terms to customers with nearly flawless payment histories. Yes, figuring out different credit terms for different types of customers takes time, but your cash flow will thank you later on.
Can Your Accounts Receivable Turnover Ratio Be Too High?
An excessively high accounts receivable turnover ratio could be attributed to at least two things.
If most of your sales transactions involve cash, your ratio will naturally be on the higher side.
If you most of your sales do not involve cash and your ratio is still excessively high, you may be assigning excessively restrictive terms. This could cause current customers to leave and dissuade potential customers from working with you. Extending your terms likely won’t hurt your ratio because these customers have already proven their ability to pay on time. You will also open yourself up to more sales and longer partnerships.
Low Accounts Receivable Turnover Ratio
Low accounts receivable turnover ratios typically stem from late-paying customers. Many companies, however, have found that it’s extremely difficult, if not impossible, to avoid such customers altogether. Besides, bigger companies tend to pay much later than requested but they also offer the most lucrative sales or contracts. Thus, you may conclude that in addition to wasting time, trying to find more punctual customers would do more harm than good to your cash flow. In this case, it’s probably best to just focus on your own collection tactics and implement some of the aforementioned strategies.
Businesses with low ratios should only reconsider partnerships with customers who can barely afford to pay them at all. Struggling customers will likely cease placing orders in the near future anyway. You might as well begin looking for better customers sooner rather than later. If these customers were struggling because of restrictive terms, your ratio would be too high, not too low.
Accounts Receivable/Invoice Factoring
Late payments can pile up to the point where they compromise your ability to cover vital business expenses. You need money now, and likely cannot wait for new collection strategies to gradually improve your cash flow. Businesses in this unfortunately common situation should look into accounts receivable/invoice factoring.
Accounts receivable factoring allows you to sell your unpaid receivables to an institution (like United Capital Source) for approximately 80-90% of the original value. That institution then assumes full responsibility for collecting from your customer. Once the customer pays the institution, you get the remainder from the first payment, minus another discount. So, instead of waiting weeks or months for the customer to pay you, the institution pays you just 2-3 days after selling the unpaid receivable. Yes, you lose a tiny portion of income. But you’d stand to lose a lot more if you let the receivable go unpaid for much longer.
Accounts receivable factoring is usually used to get over the occasional cash flow hump. It is most definitely not, however, a “last resort.” And if you work with a company like United Capital Source, you won’t have to worry about severing crucial partnerships in the process. The point of this solution is to help you accept more deals without endangering your cash flow. And yes: your accounts receivable turnover ratio will likely end up right where it should be.