The accounts receivable turnover ratio is an accounting measure used to quantify the liquidity of a firm’s accounts receivable and therefore how effectively a company uses its assets. The ratio is not just a measure of how efficiently a company collects its debts though, as the credit terms extended are also an important part of the equation.

Accounts receivable turnover is calculated using the following formula:

\(\mathrm{Accounts\: receivable\: turnover} =\frac{Net \: credit \:sales}{Average\: accounts\: receivable}\)

The ratio is generally used for a year-to-year calculation and is sometimes known as the sales-to-receivables ratio or simply the receivables ratio.

Average accounts receivable can be calculated in several different ways. Some firms take an average of the opening day of the year and the closing day of the year, and other firms use monthly averages to derive a yearly average. The monthly approach will give a more realistic result as the first method only takes into account two days from a 365 day period and ignores any cyclical changes during the year. We will however use the first method in our example to give a simpler calculation.

Example

Company XYZ had net credit sales of €60,555,132 for 2007 and its accounts receivable, net for the beginning and end of 2007, were €3,532,101 and €3,476,958 respectively. Company XYZ’s accounts receivable turnover ratio is:

In practice this means that the company collects its average accounts receivable 17.3 times each year. Looked at differently, it also means that the company takes an average of 21.1 days (365/17.3) to collect on its accounts – this figure is known as the average collections period.

Annualising

Although not common practice, some companies will monitor accounts receivable turnover on a quarterly basis. It is possible to annualise these figures by using the above ratio and multiplying the answer by four. However, this approach would not be recommended for industries where sales vary significantly throughout the year as the ratio can become distorted.

Interpretation of results

As a general rule, the higher the ratio, the tighter the company’s credit policy as the faster the business is at collecting its receivables. It is possible for credit policies to be too tight, however, and companies should consider whether they are losing out on possible sales as a result of being too restrictive. This could, in turn, negatively impact the organic growth of the company. Normally, a low receivables turnover ratio means that the business should revisit its credit policies to ensure the timely collection of its receivables. This will help the company to earn more interest as outstanding receivables are effectively interest free loans. Bad debts may also be partly responsible for a low AR turnover ratio.

Points to consider

The overall level of the ratio will vary from industry to industry and it is important to benchmark with sector peers when comparing companies.

Many companies do not disclose figures for their sales made on credit, and as such some investors will make the accounts receivable turnover calculation based on total sales. However, if all sales are included in the calculation, the resulting ratio could be skewed if the proportion of cash sales is particularly high.