What is Accounts Receivable Turnover Ratio and How Do You Calculate It? 

Smart business success means balancing sales growth and accounts receivable risk. Sales growth often comes with increased accounts receivable, both from acquiring new customers and from extending more credit to existing customers. However, if accounts receivable are growing at a faster rate than your sales, which can occur especially if you have extended payment windows, you may start running into cash flow issues.

What Is the Accounts Receivable Turnover Ratio?

The accounts receivable turnover ratio (or A/R turnover ratio) is a key financial metric that shows how quickly your business collects payments from its customers over a specified period. This data can provide important insight into your company’s cashflow, client relations, and overall stability.

Here’s an example that illustrates how the accounts receivable turnover ratio works:

Starfish Inc. is a B2B software company that delivers excellent products but lacks a streamlined credit and collections process. They don’t conduct thorough credit checks on potential clients, and have allocated minimal resources to monitoring their accounts and following up on overdue invoices. Occasionally, their clients go out of business before they pay what is owed, resulting in mounting debt. Overall, their A/R balances are high compared to their credit sales. This gives Starfish Inc. a lower accounts receivable turnover ratio, which can spell trouble in terms of their ability to meet their own financial obligations and grow their business.

By contrast, Starlight Inc. is a competitor firm that also provides highly effective B2B software solutions. But unlike Starfish Inc., they have established a robust set of policies and procedures for extending credit and collecting payments. They assess their prospective clients’ creditworthiness, promptly issue invoices with clear payment instructions, and send reminders when due dates are approaching. Because of these practices, the company’s A/R balances tend to be much lower when compared to their credit sales. This means that Starlight Inc. has a higher accounts receivable ratio, which bodes well for its ability to maintain a healthy cash flow and responsibly expand its operations.

Sometimes, the accounts receivable turnover ratio is confused with the asset turnover ratio. The latter metric provides a broader view of how well a company utilizes its total assets to generate revenue. In this article, we’ll stay focused on the accounts receivable turnover ratio, which specifically deals with credit and collections.

Why Is the Accounts Receivable Turnover Ratio Important?

As a measure of the effectiveness of your company’s credit and collection processes, the A/R turnover ratio can help to inform several critical business functions, including:

  • Liquidity Optimization – You can find out whether your business is converting receivables into cash quickly enough to ensure that your day-to-day expenses are covered.
  • Risk Assessment – This can help your business to assess its level of credit exposure and avoid taking on bad debt (or, at the other extreme, scaring away prospects with overly strict terms).
  • Performance Benchmarking– By comparing your ratio to industry peers or historical data, you can gain broader insights into your company’s practices and identify best practices to implement.

Factors to Consider When Evaluating Accounts Receivable Risk

As you consider new or current credit policies, evaluating your accounts’ credit risk is an important step. Factors to consider include:

  • Collections Timeline – Collecting accounts receivable on a reasonable timeline means your cash flow isn’t compromised and you can meet your company’s financial obligations. The longer you allow accounts receivable to go uncollected, the higher the risk you will not be able to collect on them or only collect on them partially. Setting a workable timeline, acting quickly by contacting customers on the first day their payment is late, simplifying your collections process by offering more ways to pay and even considering payment plans can help you avoid lags that compromise your cash flow.
  • Cash Flow Projections – As you grow, you don’t want to end up owing more than you can pay, so creating a cash flow projection is important. Begin by assessing how quickly you receive payments from your customers and when your payments to vendors are due. Then, begin tracking:
  1. The operating cash you have at the beginning of each month
  2. Each source of cash flow for that month
  3. Your likely business expenses (payroll, rent, loans, vendor payments)

If your cash flow projection exceeds your expenses, you’re on the right track. If not, take a deeper look at your accounts receivable.

  • Industry Averages – It’s a good strategy to compare your average accounts receivable collection period to the industry average. Often, the terms “accounts receivable collection period” is used interchangeably with “days sales outstanding” (DSO). Regardless of whichever your organization calls this period, if your ratio is higher, you may need to reexamine your credit policies and more carefully assess your customers’ creditworthiness. Divide your total accounts receivable by your average daily credit sales and compare that ratio to other businesses in your industry.
  • Accounts Receivable Concentration Ratio – Your accounts receivable concentration ratio can be determined by adding the squares of each of your customers’ percentage of your overall accounts receivable balance. Expressed as a decimal, this value will be between zero and one. A value closer to zero shows that your accounts receivable portfolio is less concentrated. Less concentration is ideal because it means your risk on nonpayment or late payment is spread out – one customer is not a make-or-break source of income.
  • Accounts Receivable to Sales Ratio – Your accounts receivable to sales ratio measures what percentage of your sales occur on credit. Too large a percentage may indicate potential cash flow risks. To calculate this metric, divide your accounts receivable balance by your total sales for a given accounting period. 

How to Calculate Accounts Receivable Turnover Ratio

This metric indicates the average amount of time it takes your company to collect payments. Here’s how to calculate it:

  1. Decide on a specific accounting period to analyze (e.g., month, quarter, year).
  2. Determine your net credit sales for that period (gross sales on credit minus returns, credits, and allowances).
  3. Determine your average accounts receivable for that same period (the sum of the starting and ending accounts receivable balances divided by two).
  4. Divide net credit sales by average accounts receivable to get your accounts receivable turnover ratio.

What is a Good Accounts Receivable Turnover Ratio?

Because the accounts receivable turnover ratio is an efficiency metric, higher numbers are typically better and an upward trend over time suggests success. You can think of this indicator like a speedometer in a sports car that tells you how fast your company is converting receivables into cash. However, just like a sports car, it’s possible to push it too far. An extremely high ratio could indicate that your credit policies are too stringent, which could damage your customer relationships and restrict growth.

Like so many things in business, there’s no universal answer to what an acceptable or optimal ratio is. Figures vary considerably between sectors and individual firms. It can be useful to look up average ratios for your specific industry to see how you measure up.

How to Mitigate Accounts Receivable Risk and Grow Sales

The health of your accounts receivable can be a good indicator of your company’s overall financial stability and growth potential. Taking a closer look at potential problems can help you mitigate risk.

Conduct Credit Risk Analysis of New & Existing Customers

Regularly evaluating the creditworthiness of your new and existing customers can protect your business from late or nonpayment on invoices. To conduct a credit risk analysis, you should: 

  • Assess customers’ or prospective customers’ financial health with the help of big data
  • Run a business credit report on each customer
  • Request trade references, when possible
  • Evaluate customers' financial statements to better understand the company’s strengths
  • Investigate regional trade risks, when appropriate

Diversify to Reduce Concentration Ratio

As mentioned above, your accounts receivable concentration ratio is calculated by adding the squares of each of your customers’ percentage of your overall accounts receivable balance. A value closer to zero means that your portfolio is less concentrated. That said, a less-concentrated and more diversified portfolio mitigates your risk for nonpayment or late payment by customers. By diversifying your client roster, you lower the risk of having an unbalanced ratio that could negatively impact your accounts receivable. If your ratio is on the higher end, you can reduce your concentration ratio and your risk by trying to initiate more sales with new customers and offering incentives for early payments with existing large customers.

Maintain & Establish Effective AR Collection Procedures

To mitigate your accounts receivable risks, you also need to examine your internal collection processes. Effective accounts receivable management enhances your company’s cash flow by reducing nonpayment or late payment. Contact management systems and accounts receivable management systems can help you process, review and access documents faster, and more easily track and report on status. Setting up and maintaining standardized collection procedures is also essential for mitigating your risk. Make sure that invoices are sent out regularly by adhering to a repeatable process.

Once an invoice is 14 days past due, reach out via an accounts receivable collections email summarizing the details of the past-due invoice, including invoice tracking number, the principal amount, any interest or fees and a description of what the original balance is for — including dates and locations. Then, thank the recipient for swift payment or a call to discuss terms.

Institute new policies, as needed, to protect your business, and set a calendar reminder now to revisit your accounts receivable process regularly to evaluate results and optimize the process.

Secure Accounts Receivable with Trade Credit Insurance

When you insure your accounts receivable with trade credit insurance from Allianz Trade, you can count on being paid, even if one of your accounts faces insolvency. This resource protects your business from the consequences of bad debts. In addition, trade credit insurance from Allianz Trade offers the support necessary to make data-informed decisions about extending credit to new clients or increasing credit to existing clients.

Discuss how credit insurance can help your business with us.
Need help with your Allianz Trade account? Get in touch by phone.
Get answers to common questions about credit insurance, claims and more.