Efficiency - Accounts Receivable Turnover Ratio

What it measures: Efficiency (in converting Accounts Receivable to cash)

How long it takes for a firm to receive money owed to it from credit sales (producing a good or service and issuing an invoice for future payment);

Liquidity / Cash Flow is critical; relatively high levels of Accounts Receivable will reduce firm liquidity;

How many times the value of Accounts Receivable goes into total sales; 

Information drawn from Income Statement (sales) and Balance Sheet (accounts receivable);

Result represented as a figure (after another step, average number of days).

The First Step equation:

Sales / Accounts Receivable

What the result means:

Higher results means that firms are more efficient at collecting their Accounts Receivable; the proportion of Accounts Receivable to Sales is low. This means that firm liquidity is not impacted by awaiting payment. 

Lower results indicate the opposite. These firms should chase down money owed, tighten conditions on credit sales, offer discounts for early payment to improve firm liquidity.

Sample Statement:

Sales ($400,000) / Accounts Receivable ($75,000) = 5.3

This firm’s accounts receivable is turned over a low number of times. This indicates poor efficiency in collecting money owed to it from credit sales. Improving the speed at which Accounts Receivable are paid will lift this result, and improve firm liquidity.

The Second Step Equation:

365 / Result from Step 1

365 / 5.3 = 68.86 days

The average number of days for this firm to receive payment from their credit sales is 68.86. This is more than double the typical trade credit terms of 30 days. This business needs to introduce strategies to decrease the number of days to ensure they have cash resources to continue to operate effectively.

See Working Capital Management strategies on Control of Current Assets for methods to improve this ratio.

Note how over time this business has improved its efficiency in collecting money owed to it from its trade credit customers. This is a good thing for the firm's liquidity and cash flow. Having too much capital tied up in unpaid accounts receivable constricts the amount of liquid cash that can be used in other business activities - like paying suppliers, employees, repairs, buying more inventory...

How to Improve the Accounts Receivable Turnover Ratio:

• Check credit ratings of clients prior to issuing trade credit

• Enforce conditions of trade credit policy (penalties for late payment)

• Build processes and systems to ensure reminders are issued to non-paying clients

• See Control of Current Assets in Working Capital Management

Less desirable methods:

• Factoring - selling your accounts receivable to a factoring agency for a discounted price. Use ONLY as a short-term measure in a cash flow crisis. You lose 5-10% of the value of the credit sale (reduced profitability to gain liquidity - competing strategic objectives)

• Discounts for early payment - same reason as above. Good for Cash Flow (liquidity), but sacrificing revenue and decreasing profitability.