Accounts receivable turnover has a lot to say about the efficiency of cash flow within an enterprise. A low turnover ratio means customers aren't paying frequently, which reduces the velocity of cash flow. A high ratio means customers pay often and the company consistently has cash coming in. Predictable cash flow means that a company can accurately plan capex and other growth projects.
While all businesses would like the highest accounts receivable turnover possible, there are a few reasons why that isn't likely to realize. The ratio is tied to the net terms offered to customers, which is largely dependent on industry standards. Despite these restrictions, there are some adjustments companies can make to improve their ratio.
Measuring Cashflow Performance With Accounts Receivable Turnover
To compute accounts receivable turnover, divide credit sales by the average accounts receivable during the period being measured. It's important that credit sales are used since we are looking accounts receivable.
As an example, let's say credit sales were $750,000 for the year. Accounts receivable on January 1 was $125,000 and on December 31 was $150,000. With these numbers, we can calculate accounts receivable turnover:
750,000 / [(125,000 + 150,000)/2] = 5.45
The number 5.45 tells us that accounts receivable turned over 5.45 times throughout the year. We can also evaluate the number of days it took for A/R to turnover: 365/5.45 = 66.97 days. If the company is using net terms of 60 days, customers are paying 6.97 days late on average.
The company will want to fix this difficulty. If it is expecting to collect payments every 60 days on average, it might begin issuing early payment discounts or pull net terms down to 50 days.
Establishing A Baseline Ratio
We know that a high ratio means more cash flow while a low one means less. But what number should we strive for? This is where a baseline can help. Think of your first baseline as a reference point. If the last four quarters show ratios of 6.1, 6.5, 5.9, 6.3, then a baseline of 5.9 to 6.5 can be established. If the next few quarters go above this range, then you might be on your way to establishing an improved baseline. But if future quarters start dipping below 5.9 and continue downward, a fix is needed.
The first method of establishing a baseline ratio is to go with the industry norm, which happens to be net 60 in this case, equating to a ratio of around 6.08.
If your industry doesn't have an average net days, the next technique is to chart your ratio. With software, you may be able to easily pull up a chart for the past few months or year. Where is the trend going? If it is heading down, you'll want to correct it, so the trend flattens and eventually begins heading up. At some point, the trend is likely to level off and may periodically dip but should recover. You're trying to avoid an extended period of declining ratio values.
Improving Your Baseline
From the above section, if your industry has net 60-day terms, you are probably stuck with those terms. Dropping below net 60 will drive away customers and going above might attract more customers but at the expense of cash flow.
If decreasing net terms isn't an option, the following can improve your turnover ratio:
- Early payment discounts.
- Make it easy for customers to pay (mail check, online, phone, lockbox, etc.).
- Offer multiple payment options (credit cards, check, debit cards, etc.).
- Send (several) reminders ahead of time about upcoming due dates.
- Automate invoicing and collections to help streamline and more easily monitor the entire process.
Looking at a turnover ratio chart, you'll be able to easily see if your efforts are have a positive impact. At some point, you'll hit diminishing returns. Meaning, for the same effort, the ratio improves very little or not at all. Once that point is reached, it will become your new baseline. If your ratio begins dropping below the new baseline for a lengthy period, it's time to figure out why and create a plan to get the ratio back up to the baseline.
Understanding your industry's net terms and trend of your accounts receivable turnover will help in creating a baseline ratio. From this baseline, it is easy to see if the ratio is improving and trying to create a new (higher) baseline or if it is beginning to head lower, signifying a problem with payment collections and eventually cash flow.
The accounts receivable turnover ratio is a great indicator of cash flow efficiency and a company's ability to collect payments from its customers. It should always be part of any KPI dashboard and an action-based data point.