Quick Guide: The Accounts Receivable Turnover Ratio
Our accounts receivable turnover calculator is a useful tool to help you calculate a company's accounts receivable (A/R) turns more quickly, but it takes more than just the calculator to use it effectively during your analysis of a company.
In this article we’ll dive into the important details that will help you calculate and use the A/R turnover ratio to enhance your financial analysis.
We’ll cover a few main points, including:
- How the accounts receivable turnover ratio is calculated and what it measures,
- Provide an example to further enhance your understanding of the ratio, and
- Summarize a quick overview of our 5 step process for analyzing A/R turns.
With the accounts receivable turnover calculator and a good understanding of the ratio, you'll have everything you need to effectively and efficiently analyze how quickly a company collects amounts owed from customers.
How to calculate accounts receivable turnover
The A/R turnover ratio is calculated by taking a company’s net credit sales during a period, and dividing it by the company’s average accounts receivable.
A/R Turnover Formula = Net Credit Sales / Average Accounts Receivable
Average accounts receivable used in the above formula is calculated using the following formula:
Average Accounts Receivable Formula = (beginning A/R + ending A/R) / 2
What does the A/R turnover ratio measure
This ratio is part of a larger family of financial ratios known as asset management ratios, or efficiency ratios, which measure how effectively and efficiently a company is managing its assets to generate cash flows for the business and generate returns for shareholders (check out our deep dive into asset management ratios, which you can use to further understand how these ratios impact your financial analysis).
The accounts receivable turnover ratio specifically focuses on how quickly, and how often a company collects cash owed to them from customers.
Evaluating a company’s accounts receivable turnover ratio will give you a good idea of how long a company extends credit to it’s customers (i.e., how long after they sell a product, or provide a service, does it take for them to actually receive payment). It can also provide insight into whether a company’s customers are financially strong, or if their customers are cash strapped and not able to pay for product or services timely.
What is a good accounts receivable turnover ratio
Analyzing whether a company has a good A/R turnover ratio depends on various factors, including the nature of the company’s operations, the trend of the company’s ratio over time, and how the company measures up to its peer group and industry competitors.
In most cases, the higher the ratio, the better. A higher ratio indicates a company is collecting cash from customers quickly, which they would then be able to reinvest into their business to generate additional returns for shareholders.
If a company's ratio is low, or slowing compared to the company’s historical A/R turns, that could be an indicator that the company’s customers are experiencing difficulty paying for products or services that were already delivered, or the company isn’t investing enough resources into growing their collections department.
The worst case scenario is that a company could have significantly aged accounts receivable amounts outstanding from customers that are never paid!
I think we can all agree that we aren’t interested in investing in a company that doesn’t get paid by its customers...
To break it down, let’s say a company has amazing customers. They never haggle on credit terms, and they are never a day late in making payments.
Because of this, the company offers credit terms of 3 days, meaning a customer owes the company for services 3 days after the company bills the customer (this is very tight, generally when companies extend credit terms to customers they are about 30 days on average).
In this scenario you would have a high A/R turnover ratio because customers are consistently making purchases and paying the company very quickly.
These are only general guidelines.
In order to use this ratio to understand how a company is performing, and use that information to confidently make a decision requires further analysis.
The 5 steps for powerful financial ratio analysis
Analyzing financial ratios can be difficult, and knowing where to start and how to complete your analysis prevents some people from ever getting started.
We'll touch on five key steps to simplify your analysis of a company's A/R turns below.
If you're interested in learning more about financial ratio analysis, including examples of how to complete and interpret the results of your analysis, we've covered this framework and walked through the below steps in greater detail here.
1. Analyze the Historical Trends of the Company
The first step in your analysis is to see what you can learn from the historical results of the Company. Once you know where a company currently stands, you can use this information to evaluate whether there are positive or negative trends that could impact the future results of the company.
2. Identify the Company’s Industry and Sector
The second step in your analysis is to research the company and identify its industry and sector. A good place to start is a company’s Standard Industrial Classification (“SIC”) Code. You can find this information in a company’s SEC filings and check out a full list of reported sectors here.
For broader industry categories, using an advanced stock screener or other research tools should give you what you need.
3. Understand the Nature of the Company’s Operations
Not all companies within the same industry or SIC classification would be a competitor of the company you are evaluating. A few examples of key characteristics to consider in your analysis are:
- Customer Base
- Life cycle of the Company
Once a company’s industry and key operating characteristics are identified, the next step is building up a list of companies with similar operations to use as a peer group in your analysis.
4. Define the Company’s Industry and Peer Group
The goal of identifying and grouping companies with similar characteristics is to use this list to accurately compare and benchmark one company’s ratio, against another. If you don’t get this part of your analysis right, it can lead to misinterpretations down the road.
There are several ways you can track down the information needed to form a peer group. Various tools and stock screeners on the web should have the information needed to analyze multiple companies.
We covered this process in greater detail in our article that walks through how to use DiscoverCI’s value stock screener to quickly find and evaluate a company’s peer group.
5. Evaluate How the Company’s A/R Turns Measure Up
At this point we’ve calculated the company’s accounts receivable turnover, we know how the Company’s A/R turns are trending over time, and we also have a solid list of comparable companies. The next step is reviewing the financial statements and ratios of the company and its peer group to see where the company lands.
An example of the accounts receivable turnover ratio
Let’s take a look at a quick example (numbers in thousands, $USD):
Apple Inc. (AAPL) reported net accounts receivable of $17,874,000 and $15,754,000 at September 30, 2017 and 2016, respectively. During FY2017 they also reported net sales on credit of $229,234,000.
Using the formulas we outlined above, you would first calculate average accounts receivable:
16,814,000 = (17,874,000 + 15,754,000) / 2
Which you would then use to calculate A/R turns:
13.63 = 229,234,000 / 16,814,000
To give you an idea of how Apple’s accounts receivable turnover ratio stacks up to a couple of its competitors, below is a chart of Apple’s historical A/R turns compared to Amazon and Google:
Evaluating a company’s accounts receivable turnover ratio will give you insight into whether a company is doing a good job of turning A/R into cash and evaluating customers' ability to pay for goods or services before extending credit.
Strong companies turn A/R quickly so they can reinvest that cash into expanding operations and growing returns for shareholders.
And as smart value investors, we like expanded operations and strong returns for shareholders.
You are now set with the accounts receivable turnover calculator, as well as the understanding and brainpower you need to calculate and analyze a company’s A/R turnover ratio, but don’t stop there!