What are the Accounts Receivable Turnover Ratio?  

The Accounts Receivable Turnover Ratio is a financial ratio that measures how efficiently a company collects payments from its customers. It is calculated by dividing the net credit sales by the average accounts receivable.  

Accounts Receivable Turnover Ratio Formula

The formula for calculating ART is:

Accounts Receivable Turnover Ratio = Net Credit Sales / Average Accounts Receivable 

To understand this formula better, let’s break it down:

Net Credit Sales: This is the total number of credit sales a company makes during a specific period. It’s important to note that we’re only considering credit sales here, which means sales made on credit to customers. We exclude cash sales since they don’t contribute to the accounts receivable balance.    

Average Accounts Receivable: This is the average balance of accounts receivable that a company carries during a specific period. To calculate this, you can add the beginning and ending accounts receivable balances and divide them by two.  

Alternatively, you can use the following formula:

Average Accounts Receivable = (Beginning Accounts Receivable + Ending Accounts Receivable) / 2  

The Accounts Receivable Turnover Ratio tells us how often a company collects its outstanding receivables in each period. For example, if a company has an ART ratio of 6, it collects its receivables six times a year. A high ART ratio generally indicates that a company is collecting its outstanding debts quickly and efficiently, which is a good sign. On the other hand, a low ART ratio can indicate that a company is having difficulty collecting its receivables, which could result in cash flow problems.  

How to calculate Accounts Receivable Turnover Ratio (ART) 

It is calculated by dividing the net credit sales by the average accounts receivable during a specific period. The formula for calculating the ART is as follows:  

ART = Net Credit Sales / Average Accounts Receivable

Here’s an example to illustrate how to calculate the ART  

Suppose XYZ Company had net credit sales of $500,000 in 2022, and the average accounts receivable for the year was $100,000. Using this information, we can calculate the ART as follows:  

ART = Net Credit Sales / Average Accounts Receivable  

ART = $500,000 / $100,000  

ART = 5  

This means that XYZ Company collected its accounts receivable five times yearly. In other words, it took approximately 73 days (365 days (about 12 months) / ART) for XYZ Company to collect its accounts receivable in 2022.  

A higher ART ratio indicates that a company is collecting its accounts receivable more quickly, which is generally considered a good sign. On the other hand, a lower ART ratio may indicate that a company is having difficulty collecting payments from its customers.  

How can one Interpret the Accounts Receivable Turnover Ratio? 

For interpreting the accounts receivable turnover ratio, there are a few key points to consider:  

1. Timeframe 

The turnover ratio should be calculated over a consistent period, typically one year, to ensure accurate comparison over time.  

2. Industry norms

Comparing a company’s accounts receivable turnover ratio to industry averages and benchmarks is important. This can help determine if the company is performing well compared to its peers or needs to improve its collection efforts.  

3. Changes over time

Analyzing the accounts receivable turnover ratio trend over time can provide valuable insights into a company’s financial health. A declining ratio may indicate that the company is having difficulty collecting payments or that its credit policies must be revised. On the other hand, an increasing ratio may indicate that the company is becoming more efficient in its collection efforts.  

4. Other factors

It is important to consider other factors impacting the accounts receivable turnover ratio. For example, a company may have a high ratio because it offers shorter payment terms or has a high proportion of cash sales. These factors should be taken into account when interpreting the ratio.  

Why is the accounts receivable turnover ratio important in financial modeling?  

A high accounts receivable turnover ratio indicates that a company effectively manages its receivables and quickly collects payments from customers. This can be a positive sign for investors and creditors, as it suggests that the company has good cash flow management and can efficiently convert its receivables into cash. 

On the other hand, a low accounts receivable turnover ratio may indicate that a company needs help collecting payments from customers or extending credit to customers that may not be creditworthy. This can be a negative sign for investors and creditors, as it suggests that the company may have cash flow issues and be at risk of being unable to meet its financial obligations.  

Conclusion

In conclusion, the accounts receivable turnover ratio is an important metric for businesses that want to track their cash flow and overall financial health. By measuring how quickly a company collects payments from its customers, this ratio provides valuable insights into the efficiency of the company’s credit and collection policies. As we have seen, calculating the accounts receivable turnover ratio is relatively straightforward, and it can be done using information readily available from a company’s financial statements. By regularly monitoring this ratio and taking steps to improve it, businesses can ensure that they effectively manage their cash flow and maximize their profitability.   

Also Read: Account Payable Vs. Accounts Receivable

Wajiha Danish

Wajiha is a Brampton-based CPA, CGA, and Controller with 17+ years of experience in the financial services industry. She holds a Bachelor of Science Degree in Applied Accounting from Oxford Brookes University and is a Chartered Certified Accountant. Wajiha spearheads Monily as its Director and is a leader who excels in helping teams achieve excellence. She talks about business financial health, innovative accounting, and all things finances.