Unpaid invoices create problems for any small company by squeezing cash flow. So, how can you prevent this problem and allow your business to breathe? The first step is to calculate your accounts receivable turnover ratio (ARTR), which can also boost the long-term financial health of your business. In this article, we will cover:
- What is accounts receivable turnover ratio, and why is it important?
- How to calculate accounts receivable turnover ratio
- How to interpret your ratio
- How to improve receivable and day ratios
- Final thoughts
ARTR is a way to understand how quickly your customers are paying up. A high ARTR means they’re paying on time. If you’re generating enough revenue and have spending under control, you should have the cash to cover costs, make accurate forecasts, strategize and invest for growth.
A low ratio suggests your clients are taking too long to pay. This could be because of poor management or credit policies, or a riskier customer base. If your business can handle it, you may try setting a lower ratio deliberately to attract customers with better credit terms.
But if there’s a problem that goes unchecked, this could lead to bigger financial difficulties, such as inability to pay your staff or suppliers. It could also affect your creditworthiness or ability to attract investment.
If you have a lower ARTR than you want, there are ways to fix it. But first you need to make the right calculations to understand your receivable ratios, including your ARTR and average days-to-pay (also known as day ratio).
What is accounts receivable turnover ratio, and why is it important?
The ARTR measures, on average, how many times your company collects the money it’s owed in a given period, such as a month, quarter or year.
Levon Galstyan, certified public accountant at Oak View Law Group, says: “A high receivables turnover ratio means your company has good customers who pay their debts quickly. So your company processes receivable balances faster and gets its hands on cashflow quicker. You can use this positive cashflow to pay your bills on time, invest in growth and plan future investments and strategy.
“A low ARTR may indicate your company has a flawed collection process, lousy credit policies, or customers who aren’t creditworthy. This may mean you cannot meet your financial obligations or invest in growth. So, you may need to look at your credit policies to address this – for example, do you check the creditworthiness of your clients thoroughly?”
In financial modelling, the ARTR and day ratio are used in balance sheet forecasts, which lenders and investors use to analyze your company’s financial health. If you have an low ARTR that you cannot address – for example, if you are at the mercy of customers who cannot pay as quickly as you need – this could affect your ability to attract finance. Or it may be why you need financing to bridge the gap.
Tanya Taylor, founder and CEO at financial education platform Grow Your Wealth, says: “Accounts receivable turnover ratio is instrumental in forecasting your cashflows. It also paints a picture of how effectively your business collects on its credit. For example, it can provide a good insight into your company’s credit policy, whether your collection department is following up, and the quality of your customers.”
A poor ratio can indicate that you need to adjust your credit policy, make changes to your credit department, or change your existing customer base.
“For example, a company with a 45-day credit policy may be tying up its short-term cashflow and limiting how quickly it can replace its inventory without taking on debt,” Tanya says. “It may also wind up with lots of bad debt on its books if these are low-quality customers; it does not have a strong collections department; or is unable to collect for some other reason.
“A company that wants to grow and or take on debt needs a strong credit policy, an effective collection department, and a good customer base that will pay their balances quickly. These attributes contribute to a higher ARTR and lower payment days ratio, which is usually the ideal for an SME.”
How to calculate accounts receivable turnover ratio
To work out ARTR, divide your net credit sales by average account receivables over a given period. So the formula is “net annual credit sales / average accounts receivables = ARTR”.
Net credit sales are those made on credit terms – for example, 30 or 45 days – minus sales returns and allowances (discounts given due to problems such as late delivery).
Receivables are the balance of money owed to you for services or goods delivered but not yet paid for. The average receivables is the average amount your customers owed to you throughout the period. Work this out by adding the starting and closing receivables at the beginning and end of the period and divide this by two.
Here’s an example.
A software company had the following financial standing for 2021:
• $100,000 net credit sales
• $20,000 accounts receivables on 1 January (the beginning of its financial year)
• $30,000 accounts receivables on 31 December (the end of its year).
The average accounts receivable is $50,000/2=$25,000. The ARTR is $100,000/$25,000=4. This shows the software company collected its receivables four times on average in 2021.
How to interpret your ratio
There is no standard good or bad figure, as it depends on the context. Three ways to interpret this figure are to compare it to your company’s previous ARTR figures, to competing firms in your sector, and to a sector average.
Take care when comparing with individual companies as each will have a different model and capital structure, which can greatly influence ratio calculations. Try and choose one in your sector with a similar size and model.
Tanya says you can make sense of ARTR further by using it to calculate the day ratio, which is how many days it takes your customers to pay their invoices on average.
She gives an example of small firm Maria’s Bakery, which has expanded its customer base by extending credit to small business owners. At the end of the first year doing this, the company’s ARTR was 8.2 – meaning it gathered its receivables 8.2 times for the year on average.
The bakery can calculate the day ratio by dividing the number of days in the year (365) by the ARTR. In Maria’s case, this is 365/8.2 = 44.5, which means it takes her just under 45 days to collect from customers.
Tanya says if the company has a 45-day payment policy, customers are paying within the terms and the system is running smoothly. If it still has cashflow problems, it may need to reduce its payment term.
But if Maria’s policy requires invoices to be paid in 30 days, a 44.5 day ratio could indicate it is extending credit to lower quality customers, or its collection department is not effective.
The bakery could compare this ratio to industry peers to see if it’s an outlier, Tanya says. “If similar businesses have a lower day ratio – say 40 – Maria’s Bakery could consider how to improve its ratios to make the business more competitive.”
How to improve receivable and day ratios
Though a high ARTR is usually desirable, you must strike a balance. If your credit policy is too strict, it may drive some customers away, especially in tough economic times. Some well-run businesses extended their payment terms to customers during the pandemic, for example. Or if a close competitor offers customers better credit terms, you may have to do the same to compete. So it’s a good idea to build some capacity to extend terms into your model and allow it to cope with such challenges.
To improve your ratio, make sure you invoice regularly and accurately. Cloud-based accounting software can automate this task to help you invoice efficiently and minimize errors.
Consider making life easier for customers by offering multiple ways to pay. Or you could ask for down payments, or bill clients in advance. Do not wait until invoices are long overdue – chase earlier, and more regularly. If clients still don’t pay, have a clear escalation process and stick to it.
Tracking invoices and receivables ratios automatically in your accounting software will ease many of these tasks, by for example, providing a dashboard and sending reminder emails to tardy clients automatically.
Keeping on top of your accounts receivable is critical to managing cashflow and enabling your business to grow. Proactivity and persistence in chasing debts will reap benefits – and accounting software takes the pain out of this process. The resulting improvements in financial health can boost your efficiency, profitability, financial standing, and the ultimate success of your business.
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