Accounts receivable turnover might seem like a complex accounting concept that requires an MBA or a CPA to figure out, but it really isn’t all that difficult to understand. In fact, most businesses don’t understand what an accounts receivable turnover ratio is – or how it is slowly killing them.
One of the most important things to understand about the account receivable turnover ratio for your business is that if you aren’t careful, accounts receivable turnover could mean the death of your business.
What is Accounts Receivable Turnover?
First, let’s start with the basics: What exactly is accounts receivable turnover? Why does it matter? Accounts receivable turnover is a ratio used to measure how effectively a company uses customer credit and collects payment on the resulting debt.
Basically, this ratio will tell you whether your customers are paying off credit quickly or if you are giving your customers credit too easily.
How is Accounts Receivable Turnover Calculated?
You can easily calculate your business’ accounts receivable turnover ratio by using the following formula:
Net credit sales ⁄ average accounts receivable
Lower numbers equal lower collections ratios, which means your business isn’t getting paid and your business is incurring debt. Higher numbers equal higher collections ratios, which means you are receiving payments and increasing cash flow.
Let’s look at an example: Your company saw $200,000 in net credit sales for the year and average receivables of $50,000. By applying the above formula, your company’s accounts receivable turnover ratio would be 4 (200,000 / 50,000 = 4).
This means that your company is collecting receivables only 4 times a year or it is roughly taking your company 91 days to collect its debt (365 days a year / 4 = 91.25 days). For many companies, they may not see this as a big deal but...
Here are 8 reasons why your accounts receivable turnover could be causing a slow, painful death for your business:
1. Your business isn’t handling credit policies properly. Your business’ low accounts receivable turnover ratio should tell you that you may be extending credit to your customers too easily. If your customers are struggling to pay back their debts, then that means the debt falls on your business. Although it’s nice of your business to pay your customer’s debts, your business is likely suffering for it. In order to sustain a healthy cash flow, it might be time to revisit your company’s credit policies.
2. Your collection practices might need some work. If you have a low accounts receivable turnover ratio, then this also mean that you need to amp up your collection practices. Sending your customers letters, statements, email reminders and making periodic phone calls reminding them to make payments is a good place to start.
3. Uncollectable or bad debts are taking down your business. Low accounts receivable turnover ratios mean your business isn’t collecting customer debts, which means your business isn’t making money and/or your business is sinking into debt. Regardless of the reason, uncollectable or bad debts are taking down your business and hurting your cash flow.
4. Customers aren’t likely to make future purchases. If your customers are struggling to pay back their debts to your business, then they aren’t likely to make future purchases. Not only is your business struggling to collect the money currently owed, your sales from repeat business purchases are also suffering.
5. You aren’t satisfying your customers. Aside from your business’ internal finances and accounts receivables, a low accounts receivable turnover ratio can also mean that you aren’t satisfying your customers. For example, when fulfillment strategies and operations begin to fail, such as shipping errors, delays and malfunctioning products, these factors can also lower your turnover rate.
6. Poor planning leads to poor performance. A low accounts receivable turnover ratio can also affect your business planning and management. If your business had an accurate and consistent rate at which debts were paid, then you would be able to better plan expenses and even future investments.
7. Tying up your business’ cash flow. If your business is using cash or even incurring debt, then ultimately you are tying up your business’ cash flow and making it difficult to make necessary purchases and even keep up with necessary expenses, such as payroll. Tight cash flow situations can make it next to impossible to plan and invest for future growth.
8. Drastically increasing your cash-to-cash cycle. Business operations typically start by investing cash to buy products for reselling or raw materials for manufacturing to put into inventory. The quicker that inventory is sold, the quicker you get cash to reinvest in revenue generating operations. Sadly companies with a low accounts receivable turnover ratio extend their cash-to-cash cycle on average another 50 days, postponing their ability to quickly reinvest in another revenue generating cycle.
The Bottom Line
Your accounts receivable turnover ratio is a number you need to understand and monitor. It shows you a lot more about your business’ finances and leniency towards extending credit to customers. The higher your ratio, the easier it is for customers to pay their debts quickly, which improves your cash flow and enables your business to put money back into the business and keep up with recurring expenses, such as payroll.
If your business has a low accounts receivable turnover rate, take it as a red flag that this is where your focus should be. Improve your policies, streamline operations, keep your doors open. If you would like to not worry about your accounts receivable at all, contact us email@example.com.