Receivables Turnover Ratio

One of the activity ratios in business is the receivables turnover ratio or rate.   This ratio measures the frequency of collecting the entire balance of accounts receivable during a standard accounting year.   The ideal turns rate is twelve with a higher value indicating an aggressive collection process.   A lower value is a warning about accounts receivable management.

For the reader to fully understand the receivables turnover ratio you must first learn how to calculate the turnover rate.   Once there is an understanding of the formula; proper application is necessary to appreciate the value this turnover ratio can generate.   Finally, this article will provide insight into evaluating the ratio when reading financial reports.

Receivables Turnover Ratio Formula

The promulgated formula for receivables turnover rate is total sales divided by the average accounts receivable balance.   As an example, it total sales were $1.6 Million and the average receivables balance was $140,000, then the turnover rate is 11.43.   This formula works perfectly with a 100% pure invoicing operation like professional firms or manufacturers.   However, the bulk of economic activity at the small business level is exit pay (payment at time of service/sale) and therefore a mix of both cash sales and sales on account exist.   A good example is a marina.   Assume their sales are $1.6 Million and half those sales are on account.   The average receivables is $70,000 per month.  Now the receivables turnover rate is 22.86. Here is the formula:

Receivables Turnover Ratio =                    Total Sales                                
.                                                  Average Accounts Receivables Balance
Receivables Turnover Ratio –    $1,600,000  =  22.86
.                                                  $70, 000

Now let’s look at the formula adjusted for sales that are invoice (on account) based and calculate the result.

Receivables Turnover Ratio =                   Total Sales on Account       .
.                                                 Average Accounts Receivable Balance

Receivables Turnover Ratio      =    $800,000 (1/2 of All Sales)    .
.                                                        $70,000 Average A/R Balance

Receivables Turnover Ratio      =    11.43

Therefore a more accurate receivables turnover ratio should exclude sales paid with cash, check, credit or debit card.   The only value in the numerator are sales directly made on account.

As for the denominator, the formula is more accurate and consistent if aged receivables are written off in accordance with a sound financial policy.   Good operations will transfer receivables aged 150 or more days to either an aged receivables account or straight to uncollectible via bad debt expense.   If using aged receivables account, the invoices are discounted to a realistic collectible value.   If aged receivables are not removed from the receivables balance, the balance will disproportionately lean towards greater stability (weighted average of uncollectible accounts increases over time) distorting the receivables turnover rate.

Allow me to illustrate.

Assume the marina has $800,000 per year in accounts receivable sales.  Invariable, 2% of all invoices are never paid nor written off.   All other invoices are collected within the normal 30 day cycle.   Let’s take a look at the continuous A/R (Accounts Receivable) balance increase and the effect on the ratio.

.               A                B                  C                    D
.                                A/R              A/R               Ending
.             Sales      Beginning    Collection      A/R Balance       Ratio
Month  On Acct    Balance    @ 987 (A*.98)   (A+B-C)     A/((B+D)/2)
.  Jan    $66,667    $70,000         $65,334          $71,333            .943
.  Feb     66,667       71,333          65,334            72,666            .926
.  Mar     66,667      72,666          65,334            73,999            .909
.  Apr      66,667      73,999          65,334            75,332            .893
.  May     66,667      75,332          65,334            76,665            .877
.  Jun       66,667      76,665          65,334            77,998            .862
.  Jul        66,667      77,998          65,334            79,331            .847
.  Aug      66,667      79,331          65,334            80,664            .833
.  Sep       66,667      80,664          65,334            81,997            .820
.  Oct       66,667      81,997          65,334            83,330            .806
.  Nov      66,667      83,330          65,334            84,663            .794
.  Dec      66,667       84,663          65,334           85,996             .781
.           $800,000                                                                      10.29

Ideally, an excellent indicator of accounts receivable turnover is a consistent value from one time period to the next.    If there were no collection issues the turnover rate for the year would be 11.43, with this continuous increase of uncollectible accounts the turnover rate has dropped to 10.29,  a full turn less.

So there are some basic rules in using this activity ratio.   The first is proper application of the rate.

Proper Application of the Receivables Turnover Rate

The key to this ratio is realizing that it measures the ability to collect the receivables in a timely manner.   The derived rate is either compared to the historical trend or compared against a standard.  If the resulting value decreases from the average or standard it is a clear sign that either there are collection issues or the overall accounts receivable age is increasing.

Here is an illustration:

Mattress Manufacturing

In a year, mattress manufacturing sells $3.4 Million in mattresses, all on account.  Sales are stable throughout the year.   The average age of invoices is 22 days. Therefore the average accounts receivable balance is $207,778 ($283,333/month in sales * 22/30).   The average turnover rate is 1.36 per month; which is very high (good).   This equates to 16.36 per year.   The accounts receivable manager goes on a three month maternity leave.   During this period the average age of accounts receivable increases to 28 days.  What is the resulting turnover rate?

28 day average equates to $264,444 ($283,333 * 28/30) in accounts receivable.   The turnover rate decreases (poorer) to 1.07 from 1.36 or annualized as 12.86 down from 16.36.

With the circumstance illustrated above, this is an aging issue.   Let’s modify the above and change the conditions.   Same company, same sales and accounts receivable manager with an average age receivables of 22 days.   One of the customers is a three store retailer that purchases $50,000 per month of mattresses.   Always pays his bill within two weeks making him an excellent customer.   He suddenly dies and he left no will or gave signatory rights to anyone else in his company.   His case is tied up in a legal quagmire.   His company’s account goes unpaid; worse yet, there are no orders.   Let’s see the results of the turnover rate.   The customer dies on the first day of month number 2.

Month    Sales       Average A/R Balance  A/R Turnover Rate
.  1       $283,333           $207,778                   1.36

.  2         233,333             214,444                   1.09
.  3         233,333             221,110                   1.06

This customer’s death immediately distorts the turnover rate and will continue to distort without some form of rectification of the uncollectible balance. In this case the company does have a policy that transfers out of receivables into a legal claim account any receivable older than 90 days.   So in month four, the $50,000 balance is removed from the accounts receivable into a legal claims account.   Now look at the turnover rate.

Month    Sales    Average A/R Balance    A/R Turnover Rate
.  1      $283,333         $207,778                        1.36

.  2        233,333           214,444                        1.09
.  3        233,333           221,110                        1.06
.  4        233,333           196,110                        1.19
.  5        233,333           171,110                        1.36

The average turnover rate returns to normal.   The turnover rate during this five month period looks like a shallow ‘U’ when graphed.  The outcome of this illustrates another aspect of proper application of the formula.  It can not identify the level of sales, sales performance or any element of the income statement.   It is strictly a tool to evaluate collection performance or identify the existence of an accounts receivable issue.

Key Business Principle

THE ACCOUNTS RECEIVABLE TURNOVER RATIO MONITORS COLLECTION PERFORMANCE OVER TIME OR IS USED TO IDENTIFY EXISTING ISSUES WITHIN THE PORTFOLIO OF RECEIVABLES.

To take this further, this ratio is not a good barometer of business performance; it is really more of a management evaluation tool.   There are several variables that greatly impact the rate over time and include:

* Changes in Customer Credit Ratings
* Sudden Expansion or Retrenchment of Sales on Account
* Increases in Amount of Time to Pay on Accounts
* Conversion to Revolving Charge Accounts 

The final aspect of understanding and using the accounts receivable turnover rate is learning how to read the information presented in reports.

Insights With Accounts Receivable Turnover Ratio

Many accountants and sophisticated finance managers miscalculate the accounts receivable turnover ratio (rate).   Almost every time they use total sales as the numerator.   When questioned about the accuracy increasing if restricted to only sales on account they respond with the primary concept of  ‘Its an indicator over time; as long as you use the same numerator source there are no errors in the trend line’.   Basically they are saying that you are measuring the value over time so it doesn’t matter if you use total sales.   This is true;

EXCEPT …

What happens if the mix of cash sales to sales on account change?   You will get false or misleading outcomes.

Look at this table for Widget Company, a manufacturer.

.                               Ratio of Sales       A/R           Average        A/R       A/R Turn Ratio
Month   Sales      Cash/On Account    Sales      A/R Balance    Ratio   Account Sales Only
1         $500,000           50/50           250,000        $250,000       2.00            1.00

2           500,000           45/55           275,000          262,500       1.90            1.05
3           500,000           55/45           225,000          243,750       2.05              .92
4           500,000           52/48           240,000          241,875       2.07              .99

Notice in month two the misinformation using all sales as the numerator.   The turn rate decreases when in reality collections actually remained stable in comparison to sales on account.   The exact opposite happens in the third month.   Using all sales when there is a mix is mathematically risky.   It only works if the mix is stable.

The above example changes the mix a mere 10% and the results are very misleading.  People have been fired by the misapplication of the formula.

Another misuse of the accounts receivable turnover ratio is its use in certain businesses.  The reality is that certain sectors and industries are inherently cash based and sales on account are infrequent or of little bearing in any decision model.  The following are examples: 

* Housing Industry  – rents are paid prior to occupancy
* Food Service   customers pay at time of consumption of their meal
* Hair Salon – exit pay system
* Traditional Retail – exit pay system

There are many others.  Receivables turnover ratio is mostly prominent in the service sector, manufacturing, distribution, transportation and medical sectors.

One final insight into this turnover rate.   Most often improvements or downturns are temporary.   Over time the value will fluctuate around a certain standard.   Any average collection ability less than 30 days yields a higher value than 12, longer than 30 days and the turnover rate decreases to below twelve.  The following table illustrates some of the average age of receivables (collection time period) and the resulting turn rate values.     

Average Age          Accounts Receivable
of Receivables          Turnover Rate
15 Days                        24.00

18 Days                        20.00
21 Days                        17.14
24 Days                        15.00
27 Days                        13.33
30 Days                        12.00
33 Days                        10.91
36 Days                        10.00
39 Days                          9.23

Most businesses target 30 days for an annual turnover rate of 12.   Ideally 21 to 24 days should be the maximum number of aging days for invoices.   This results in turn rates between 15 and 17.

Summary

The accounts receivable turnover ratio measures how often over the course of an accounting cycle (one year) the accounts receivable is collected.   The formula is:

Receivable Turnover Rate  =                    Sales on Account                 .
.                                                 Average Accounts Receivable Balance

Proper application requires evaluating the outcome over several periods of time or comparing the outcome against a standard.   Although it is considered an activity ratio, it is really a poor measurement tool for business performance.   It is more suited as a management monitoring device.   For some industries such as high cash based or prepaid operations, the tool is irrelevant.   ACT ON KNOWLEDGE.

If you have any comments or questions, e-mail me at dave (insert the usual ‘at’ symbol) businessecon.org.  I would love to hear from you. If interested in my services as an accountant/consultant; click on ‘My Services‘ in the footer of this article. 

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About David J Hoare 427 Articles
I spent 12 Years as a Certified Public Accountant, Over 20 Years of Practice in Accounting and Consulting, Controller in Management of Closely Held Operations, Masters of Science in Accounting, Prepared over 1,000 Business Tax Returns and Hundreds of Individual Returns