Account receivable turnover ratio is basically used to calculate the financial efficiency of the company. This ratio indicates the capacity of turning receivables into cash. This is calculated through the formula for the account receivable turnover ratio.
This formula is used to calculate, How many times your business can turn its accounts receivable into cash during a particular period ?. Basically, the account receivable turnover ratio mainly calculates how many times one business can collect its receivable during a year.
This ratio is an accounting measure that is used to measure a company’s efficiency in turning its receivables into cash. The accounts receivable turnover ratio basically shows how effectively a company manages its credit. And it is a benchmark to know how much we can give credit to customers. How quickly the company collects its debt.
What is Formula for Account Receivable Turnover Ratio?
How to analyze the account receivable turnover ratio?
Below are the three type of different scenario of a company
ABC company accounts receivable has turned over 12 times during the year, which means that the company collects cash within 30 days of average account receivable.
XYZ company accounts receivable has turned over 6 times during the year, which means that the company collects cash within 60 days of average account receivable.
PQR company accounts receivable has turned over 1 time during the year, which means that the company collects cash within 304 days of average account receivable.
How to know the financial position from Account Receivable Turnover ratio.?
From the above example
ABC Company has good Account receivable collection systems they collect Account receivable and they had good Debtors who pay money on time. ABC Company has good cash available in hand to pay his accounts payable. This ABC company cash ok company
XYZ Company has average Account receivable collection systems they collect Account receivable and also they had Average Debtors, who pay money a little late.
XYZ Company has not good cash available in hand to pay his accounts payable. This XYZ company cash is under little deficit
PQR Company has bad Account receivable collection systems they collect Account receivable and they had Bad Debtors, who don’t pay money on time and pay very late. PQR Company has deficit cash in hand to pay his accounts payable. This PQR company cash is under complete deficit.
The above analysis many depends upon Company under which product and services. Some company whose volume is less but the prices of the product is high. Then accounts receivable turnover 12 times is also a bad ratio.
What is the meaning of high Accounts Receivable Turnover Ratio?
As we had mentioned, their general rule of thumb is that higher the accounts receivable turnover is better. A higher ratio which, therefore, mean:
1) The company receives payment for debts, which had increases your cash flow.
2) Methods of collections are effective.
3) Extending credit to the right kinds of customers. Meaning you take in business bad debt.
4) Customers are quickly paying off debt, freeing up your credit lines for future purchases.
5) Finally. it’s good noting to have a high ratio could also that mean that you can operate largely on a cash basis instead of as a credit sale.
6) Moreover, a typically higher accounts receivable turnover ratio is more preferable. there are scenarios in case your ratio could be the result of too high.
7) A mainly too high ratio can lead to mean that credit policies that are in a company are too aggressive which can sometimes lead to upset a customer or sometimes miss your sales opportunity from a customer with slightly to lower credit policy.
In case, you might reconsider your adopted credit policies to possibly increase your sales as well as to improve your customer satisfaction.
Accounts receivable turnover ratio is one of the accounting measures that is used to quantify the company’s efficiency measures taken for collecting receivables.
When accounts receivables turnover ratio are high and the turnover ratio will indicate that the collection method of accounts receivable is followed efficiently and the company a high level of the proportion of good customers that normally pay debts quickly.
What is Low Accounts Receivable Turnover Ratio?
If you had a low account receivable turnover ratio. It seems that the system which is followed is not effective in collecting their debt payments in regard to your sales. Which in turn below is the indication for a few results of indication in your business:
1) There not Company collections policies that seem to be not effective.
2) The Company is giving credit to customers without looking at customer capacity.
3) Bad Debt is paining to your cash flow.
4) It seems that your customers are struggling to make your payments. This results in low sales in the future.
5) However, low accounts receivable turnover measures will indicate problems in your business. Seems that credit or collections processes are not followed as per policy.
6) When any company some time fails to give proper satisfaction to customers. This will be through a shipping wrong quality product malfunction and that needs to be replaced, to your company turnover may get slow.
7) Therefore, if your accounts receivable ratio is low. Then you want to take into consideration a variety of factors that may contribute.
8) Once you had identified the problem. Evaluate how you can change and get better your to practices to improve the accounts receivable turnover ratio.
9) When our accounts receivables turnover ratio is low this might be due to which company has set up a poor kid to the collection process, and bad credit policies or dealing with the customers that are not financially good.
The company’s accounts receivables turnover ratio should be frequently monitored and list the tracked to determine the measure and need to take appropriate action. This in order to track company cash flow.
Below consideration which many happen when you calculate receivables turnover ratio:
You may use total sales instead of credit Sales in the numerator for the above formula for accounts receivable. Total Sales include cash sales. This will get result in a misleading answer also if the cash sales proportion is high. This will lead to a high ratio which is not the situation of the company.
When there is a low ratio of accounts receivable turnover the number will be a signal into an unreasonably restrictive credit policy, The manager who is giving credit is to allow credit sales to only creditworthy customers.
There are just two important points at the time of measuring is the beginning and ending accounts receivable closing balances are for the measurement year, and you need to take the balances on two dates vary considerably from average amount during the entire year.
It is important to use a method that to arrive at the average accounts receivable balance, Basically the average ending balance for all the 12 months of the year.
Sometime a high receivable turnover result may not be the fault of the staff of collections staff. Otherwise, it is possible that the errors made in another department of the company who is responsible for preventing payment. For example, if goods or services delivered are defective or goods are shipped and customers may deny paying to the company. Thus, For this reason, to blame for a poor ratio result may be the reason of another department of a business.
What is the understanding of Accounts Receivable Turnover Ratio?
As mentioned, the accounts receivable turnover ratio is basically used to know and measure the company’s effectiveness on how you are efficient in collecting your receivables. Therefore, once your ratio is lower, the more you take times in turning your accounts receivable which means your fund of the company is a block and your cash is with the Customer of the company.
This is a serious problem that your company cash is used by the Customer to their needs. A serious issue that it has become the trend that the customers are using the cash of your company and using it you are paying their payables.
Instead, a high accounts receivable turnover improves the cash flow of your company and allows you to regularly pay your business’s debts, just like payroll, as an example, and more quickly. A higher ratio means that it is more likely that business will ultimately receive the payments for the debts and instead of having being written off as bad debt. This is a sign of a company with a financially healthier business and results that they had a good customer to pay their debts.
In addition to calculating the speed of payments you will be receiving, this ratio can also indicate that how well is your business handles customer credit policy and practices as well as manages customer debt efficiently or not.
What is Significance of Your Accounts Receivable Turnover Ratio?
Your accounts receivable turnover ratio will be an important marked figure for the planning and business management.
Once you have learn to how quickly that your debts are being paid. You can plan to try to ascertain it.
It will help to forecast your cash flow which in order to get better plan your expenses payables.
It will help to focus on your collections on a issues to improve a cash flow. This can also help you to again reinvest in your business for an additional company growth.
It helps to improve your ratio which will also help you to get a business loan. As many loans are used accounts receivable in terms of security as collateral for Bank Loan.
By improving your accounts receivable turnover ratio. You can improve your level of collateral which can offer and make your loan terms satisfy to bank condition.
How to Track Your Accounts Receivable Turnover Ratio?
Accounts receivable turnover is an accounting principle but it is crucial to your business.
You need to implement that in your regular process of meeting with the functional team that weekly or monthly account receivable ratio is tracked regularly.
You need to have updated policies according to the customer behavior.
Measure to be taken to improve accounts receivable in the right direction.
You need to educate your bottom line. By tracking accounts receivable turnover rate over time to time.
You can get a view to know how your business can be extended and get collects credit and you can see whether trends keep on moving in the right direction period after period.
Moreover, with the regard in order of your future business financing. Some of the lenders will look at the accounts receivable turnover ratio which will help them to decide if they should go ahead with your existing business.
When you are comparing two kind of similar businesses. The one with the higher receivables turnover ratio may be a much smarter investment for the lender to your business making it them even more important to you to track at yours and further improve it.
Shortcomings of Accounts Receivables Turnover Ratio?
We had discussed the metric ratio is important in assessing your business in order to improve collection. You will need to know this ration help but it has many limitations.
It will not identify which is your bad customer. Exact name of the customer which you need to take corrective action.
It takes time to review each time the receivable and may the outstanding for some other reason.
Some market condition it will not able to highlight. The exact issue to nonpayment by the customer.
It can’t help you to identify the bad customer accounts that you need to review extra, such as those over 180 days past due.
Additionally, since this ratio is only based on an average. It can be distorted by the customers who can outstandingly quick and similarly with by accounts seems to pay it extremely slow. Thus making this data a very less accurate to measure the your credit effectiveness.
Furthermore, the accounts receivables ratio can thus may throughout the year on a seasonal basis. Which means that your ratio will be skewed just simply based on the start and the endpoint of you’re the average. Therefore, you need to look at account aging in order to ensure that your ratio is an accurate found of the picture of your customers’ pay.
Lastly, when you are comparing different type of companies accounts receivables turnover ratio. The only those companies who are into same industry or niche and have similar kind of business models should be taken into comparison.
Just Comparing accounts receivables turnover ratios of companies that are different sizes or different capital structures is not a useful for comparison and you should be alert such in doing so will not give you correct data.
Corrective measure to be taken to improve the Account receivable turnover ratio
Develop the regular review system from the data received from accounts receivables measurement team.
Develop policy for credit to be given to customer.
Take something in return from the customer in giving credits. This may be bank guarantee or standby letter of credit.
Review customer financials before giving large credit to customer.
Establish proper reminder system to the customer for delay in the payment.
Develop the action plan to collect with the customer who is not giving the payment.
Conclusion At last after the discussion we found out the account receivable turnover ratio is important to measure to calculate the company performance. In terms of collection of cash from the receivable. It helps make an alarm in the company that the company is losing cash in receivable is getting delay. The Formula for account receivable turnover ratio must be used regularly. Even if calculating and understanding and implementing the accounts receivable turnover ratio seems to be a difficult task at first, but in reality, it’s rather simple in measuring it. This ratio will help to become a cash surplus. Once you implement the accounts receivable turnover formula in order find out your ratio. It will help you to identify issues of your business’s credit practices and also help improve cash flow.