Quick Guide: The Accounts Receivable Turnover Ratio
The accounts receivable (A/R) turnover calculator is a useful tool to help you evaluate A/R and cash collections. But there are a few other key points you should know about calculating A/R turns.
In this article we’ll cover a few main points, including:
- How the accounts receivable turnover ratio is calculated,
- What the A/R turnover ratio measures, and
- An example to further enhance your understanding of the ratio.
By the end of this article you'll have everything you need to analyze how quickly a business collects payments from customers.
How to calculate accounts receivable turnover
The A/R turnover ratio is calculated using data found on a company’s income statement and balance sheet.
First, use a company’s balance sheet to calculate average receivables during the period:
Average Accounts Receivable Formula = (beginning A/R + ending A/R) / 2
Next, divide the average receivables balance by net credit sales during the period. Cash sales would be excluded from the sales number:
A/R Turnover Formula = Net Credit Sales / Average Accounts Receivable
What does the A/R turnover ratio measure?
The A/R turnover ratio is part of a larger family of financial ratios known as asset management ratios, or activity ratios. These ratios measure how efficiently a company is managing its assets to generate cash flows for the business.
For more details on these ratios, check out our deep dive into asset management ratios.
The accounts receivable turnover ratio measures how fast, and how often, a company collects cash owed to them from customers. The ratio tells you the average number of times a company collects all of its accounts receivable balances during a period.
It also provides insight into whether the business has financially strong customers, 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 many factors.
These factors include:
- The nature of the company’s operations,
- The trend of the company’s ratio over time, and
- How the company’s ratio 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. By collecting cash more quickly a business can reinvest that cash to generate additional returns for shareholders.
Be careful if a company's A/R turns are low, or slowing compared to the company’s historical turnover ratio. This could be an indicator that the company’s customers aren’t paying for products or services that were already delivered. It could also mean the company isn’t investing enough resources into growing their collections department. Not good!
The worst case scenario is that a company could have money due from customers that is never paid! We can all agree that investing in a company that doesn’t get paid by its customers is a bad idea.
To break it down further, 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 ten days.
In this scenario, the company’s A/R turnover ratio would be high. Why you ask? Because customers are making purchases and paying the company very quickly, which means better cash management for the company!
These are only general guidelines.
Analyzing financial ratios can be difficult. Knowing where to start and how to complete your analysis prevents some people from ever getting started.
If you're interested in learning more about financial ratio analysis, we've covered this framework in greater detail here.
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
Let’s get an idea of Apple’s accounts receivable turnover compared to a couple of its competitors. Below is a chart of Apple’s historical A/R turns compared to Amazon and Google:
Is a business doing a good job of turning A/R into cash? Is their credit policy established? Are they evaluating a customer’s ability to pay for products or services before extending credit?
These are questions that can be answered by evaluating a company’s A/R turnover ratio.
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 have the accounts receivable turnover ratio calculator, the A/R turnover formula and your brainpower. Everything you need to analyze a company’s A/R turnover ratio!
But don’t stop there if you’re looking to invest in companies with impressive A/R turnover ratios.
Use our customizable stock screener to find undervalued companies with high accounts receivable turnover ratios.