As a firm that specializes in accounts receivable factoring for small business, a big part of our success lies in our intimate knowledge of how business accounting works. We make it our business to know and understand things like the accounts receivable turnover ratio. Do you know what that is?
If you don’t, you will by the time you finish reading this post. And if you do, are you aware of your company’s current accounts receivable (AR) turnover ratio? It is great to know the definition, but if you don’t know where your company currently stands, the lack of knowledge could be hurting your cash position.
Before we get into the AR turnover ratio, just a reminder that Thales Financial helps customers maintain consistent cash flow through invoice finance. We help companies turn accounts receivable into cash by purchasing outstanding invoices. With that said, let us get to the main topic of this post.
The AR Turnover Ratio Defined
The AR turnover ratio is a measurement of how effectively a company is collecting payments from customers who purchase on credit. As a ratio rather than a flat number, it provides a more accurate picture of the total results of the company’s collection efforts. Figuring out the AR turnover ratio is pretty simple. Here’s the formula:
AR turnover ratio = net sales (on credit) ÷ average receivables
For the purposes of this formula, net credit sales include all sales on credit regardless of how that credit is proffered. It doesn’t account for operating costs, wages, etc. It is simply the revenue generated by sales on credit.
Average receivables is the amount of that revenue still outstanding on a periodic basis, usually whenever the ratio is calculated. You might calculate every quarter. So to get the average receivables, you would average the outstanding amounts due for each month of the quarter.
Plug in the numbers and the result tells you how effectively your company is collecting. The higher the ratio, the more efficient and productive your collection efforts are. A lower ratio tells you just the opposite.
When the Ratio Is Low
Calculating the AR turnover ratio can be instrumental in helping management understand a company’s cash position. For starters, a ratio indicating the company is collecting less than half of what is owed on credit sales over the course of the designated term suggests significant cash flow problems. If the company doesn’t correct things, it will continue falling further behind.
This indicates inefficient and unproductive collection methods. There are plenty of ways to address it, including reducing credit limits, reducing terms, and following up on invoices more aggressively.
When the Ratio Is High
The other side of the coin is a high AR turnover ratio that doesn’t seem to eliminate cash flow problems. In such cases, there can be any number of factors in play. A company could be spending too much money. Another possibility is that the company extends a lot of credit but does not use credit itself.
Regardless of the reasons, invoice factoring is one way to minimize cash flow problems in the short term. We work with all sorts of companies that find themselves in a cash pinch despite having comparatively high AR turnover rates. It happens. Occasionally running into cash problems is normal in business.
Knowing your company’s AR turnover ratio is important to understanding how efficiently the accounting department is collecting on credit sales. Do you know your company’s ratio? If not, it is time to change that. The more you know about accounts receivable, the better your understanding of the company’s overall financial health.