Accounts Receivable Turnover Ratio – its importance and how to calculate

Accounts Receivable turnover ratio, categorized under Activity Ratios, is one of the key metrics measured by companies to assess the company’s financial health and can provide insight into a company’s ability to collect outstanding invoices.

To evaluate a company, Accounts Receivable turnover ratios are used by investors and analysts to assess its liquidity and determine the effectiveness of its credit and collection policies.

In general, Activity Ratios are calculated on the basis of the cost of sales or sales. Therefore, these ratios are also called “Turnover Ratios”.  Turnover indicates the speed or number of times the capital employed has been rotated in the process of doing business. In other words, these ratios indicate how efficiently the working capital and inventory are being used to obtain sales.  Higher turnover ratios indicate better use of capital or resource and, in turn, lead to higher profitability.

Some important turnover ratios are –

i)           Accounts Receivable Turnover Ratio ( ARTO )

ii)          Accounts Payable Turnover Ratio

iii)         Inventory Turnover Ratio 

iv)         Working Capital Turnover Ratio

Accounts Receivable Turnover Ratio:

This ratio indicates the relationship between revenue from operations and average accounts receivables during the year.

Accounts receivable turnover ratio =    Credit Revenue from Operations ( Credit Sales ) / Average Accounts Receivable    =   ….. times    

Average accounts receivables are calculated by adding the accounts receivable at the beginning of a period as well as at the end of the period and by dividing the total by two.

While calculating this ratio, the provision for bad debt and doubtful debts is not deducted from total accounts receivable, so it may not give a false impression that accounts receivable are collected quickly.

The significance of the Accounts Receivable turnover ratio is that this ratio indicates the speed with which the amount is collected from accounts receivable. The higher the ratio, the better it is. It indicates that the amount from accounts receivable is being collected more quickly.

The more quickly the accounts receivable are collected, the less the risk from bad debts, and so the lower the expenses of collection and increase in the liquidity of the firm. A lower accounts receivable ratio will indicate a need to revisit the accounts receivable management process and tighten the firm’s credit sales policy. It also means that credit sales have been made to customers who do not deserve much credit and expose your company to losses due to bad debts.

Accounts Receivable turnover ratio can also be converted into the number of days within which the cash is collected from accounts receivable :

Average Collection Period   =      365 / Accounts Receivable turnover ratio   = ……. number of days                           

If the Average Collection Period is 45 days means that, on average, accounts receivable take 45 days to get converted into cash. In other words, credit sales are locked up in accounts receivable for 45 days.

An increase in the average collection period indicates the blockage of funds with accounts receivable, which increases the risk of bad debts. A higher average collection period is, thus, an indication of the inefficiency of the accounts receivable management process or high customer dissatisfaction.