What Is The Formula For Accounts Receivable Turnover Ratio?
By Indeed Editorial Team
Published 26 October 2022
The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.
Many financial models and metrics measure business performance using specialised tools, formulas and equations. One such approach is to assess how often a business collects its average receivables during a period. If you are an accountant, senior business leader or investor, knowing this value can help you determine the financial health of the company and provide other unique insights. In this article, we define the accounts receivable turnover ratio, share its formula, discuss the meaning of a high receivable turnover ratio, describe how to calculate it and provide an example.
What Is The Accounts Receivable Turnover Ratio?
The accounts receivable turnover ratio refers to the efficiency of a company in collecting its outstanding accounts receivable amount. To use the revenue companies generate from credit purchases, they collect accounts receivables at regular intervals. The receivable turnover ratio is suitable for assessing a company's effectiveness in managing its line of credit and outstanding balance. Besides helping compare how well different companies manage their clients and finances, this ratio can help businesses understand their competition, improve internal collection or renewal processes and enable investors to identify potential investment opportunities.
It is essential to note that companies may collect the outstanding accounts receivable at different times. Companies that offer credit services or products for which the customers can pay later may use longer durations to calculate their receivable turnover ratio.
Accounts Receivable Turnover Ratio Formula
The formula for the receivable turnover ratio is:
Accounts receivable turnover ratio = Net credit sales / Average accounts receivable
In this formula, there are two main elements, including:
Net credit sales
Net credit sales is the value of the cash the company collects at a later date. These are the sales after deducting the value of any returns or refunds, and the formula for calculating it is:
Net credit sales = Gross credit sales - Returns
The receivable turnover ratio uses net credit sales instead of cash sales, as cash sales do not lead to any receivables. Most companies provide their net credit sales in their income statement.
Average accounts receivable
The average accounts receivable is the sum of a company's starting and ending accounts receivable figure in a selected period, divided by two. For example, suppose you want to calculate the average accounts receivable of a company for a quarter. In that case, you can add the company's receivables at the beginning of the quarter and the end of the quarter and then divide the sum by two. Here is the formula to calculate this value:
Average accounts receivable = (Beginning accounts receivable balance + ending accounts receivable balance) / 2
What Is The Meaning Of A High Accounts Receivable Turnover Ratio?
A high receivable turnover ratio simply means that a company can collect its outstanding cash in the accounts receivable more times. For example, if a company's receivable turnover ratio is two, it implies that the company collects its outstanding amount twice in the year. Similarly, the company collects its receivables four times a year if the ratio is four. A higher ratio signifies that the company or business collects the accounts receivable consistently and accumulates cash periodically against existing obligations. This also suggests that the company has a trustworthy and consistent client base.
A low receivable turnover ratio is usually unfavourable, as it implies that the company is inefficient in collecting its outstanding receivables. A low ratio may also indicate ineffective payment collection policies and that clients may not be reliable, as they do not clear their debts on time. In such a scenario, the company can reassess its credit policies and revise its collection processes to ensure a greater success rate in collecting outstanding revenue.
How To Calculate This Ratio
The receivable turnover ratio is a vital measure of a company's finances as it helps determine how frequently it can collect and use the debts owed towards the credit extended. Follow these steps to find out how to calculate the receivable turnover ratio:
1. Evaluate your balance sheet
Before calculating the ratio, it is essential to review the company's balance sheet and identify relevant figures. Get specific details, like the accounts receivable value for the beginning and end of the designated period, gross credit sales and the returns. Verify these figures from different company documents to ensure they are accurate and final.
2. Calculate the net credit sales
To calculate the net credit sales, you can subtract the returns from the gross credit sales. For example, if a company had gross credit sales of ₹80,000 and the returns are ₹20,000, you can find the value of the net credit sales by applying the required formula. Subtract ₹20,000 from ₹80,000 to get ₹60,000 as the net credit sales value.
3. Determine the average amount receivable
Next, calculate the average amount receivable to find the accounts receivable ratio. To find this value, add the amount receivable at the beginning and end of the defined period and then divide it by two. For example, if a company had a starting receivable balance of ₹25,000 and an ending receivable amount of ₹40,000, you can calculate the average account receivable using its formula. Add the two accounts receivable balance figures to get ₹65,000. Next, divide this number by two to get the average accounts receivable as ₹32,500.
4. Determine the receivable turnover ratio
With all the components of the main formula calculated, you can now derive the receivable turnover ratio by dividing net credit sales by average accounts receivable. For example, if a company's net credit sales are ₹50,000 and the average accounts receivable is ₹20,000, then using the formula, divide ₹50,000 by ₹20,000 to get a ratio of 2.5. An account receivable ratio of 2.5 implies that the company collects its revenue every 146 days.
5. Compare current ratio with past company data
If you are analysing the financial performance of the company from different time periods, compare the current value with past company data. An increasing accounts receivable ratio indicates better collection and payment from clients. Conversely, a decreasing ratio can suggest that the company may require a revision in its collection and credit policies.
Example Of Calculating This Ratio
Here is an example of the calculation of a company's receivable turnover ratio:
The accounting department at Wavewood Inc., a multinational company, is using the company's balance sheet to calculate the company's receivable turnover ratio. As per the information in the balance sheet, the company had gross credit sales worth ₹70,00,000 and ₹5,00,000 in returns. Further, the company had ₹24,00,000 in accounts receivable at the beginning of the year and currently has ₹40,00,000. Using this data, the accountants calculate the net credit sales by subtracting the returns of ₹5,00,000 from the gross credit sales of ₹70,00,000 to get ₹65,00,000 of net credit sales.
Next, the accountants add the two account receivable values of ₹24,00,000 and ₹40,00,000 and divide the sum of ₹64,00,000 by two to get ₹32,00,000 as the average accounts receivable amount. Then, they divide the net credit sales (₹65,00,000) by average accounts (₹32,00,000) to get a turnover ratio of 2.03. This means that the company's accounts receivable team collected the average accounts receivable amount two times over the entire year. By comparing this ratio to past data, the accountants can identify whether the company's accounts receivable efficiency has improved or not.
Please note that none of the companies, institutions or organisations mentioned in
this article are associated with Indeed.
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