Accounts receivable turnover rate is one of many key performance indicators (KPIs) that a company can use to measure their success in collecting customer debt. This rate lets companies know how quickly they are collecting their accounts receivable and how many days their customers take to pay them, on average. Knowing this information, credit managers can decide whether they need to improve their collections procedures or revise their credit policies.
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What is Accounts Receivable Turnover (ART)?
A company’s accounts receivable turnover rate (ART) — also called “receivables turnover ratio” or “debtor’s turnover ratio” — measures how quickly short-term debt is collected or paid by customers. It shows how many times receivables are converted to cash in a certain time period. Generally speaking, the higher the number or ratio, the more successful the company’s collections are. The ART can be calculated on a monthly, quarterly, or yearly basis.
Once the accounts receivable turnover has been calculated, a company can use that ratio to determine how long it takes them to collect on their receivables, which is called the average duration of accounts receivables. This lets the company know how long, on average, receivables stay on the books. This can be a good measure of the efficacy of a company’s collection procedures.
How to calculate your ART
The accounts receivable turnover rate is calculated by dividing net credit sales by the average accounts receivable balance for the time period.
Accounts receivable turnover rate = net credit sales / average accounts receivable balance
Net credit sales are calculated by subtracting returns from the revenue from sales on credit for the period.
The average accounts receivable balance is calculated by adding the beginning AR balance to the ending AR balance and dividing by two.
Then, to calculate the ART, divide net credit sales by the average AR balance. If you want to use this rate to calculate the average duration of accounts receivable, or how long it takes your customers to pay, divide the ART by the number of days in the time period.
Example ART calculation
We’ll be measuring the ART for a month that had 31 days. The net credit sales for the month were $100,000. The beginning AR balance was $50,000, and the ending balance was $75,000.
To calculate the average AR balance, add $50,000 plus $75,000 and divide by two, which gives us $62,500.
The accounts receivable turnover rate for the month is calculated by dividing $100,000 (net credit sales) by $62,500. We get an answer of 1.6. This means the company has collected 1.6 times the average receivables in the month.
To get the average time it takes our customers to pay their balances, we take 1.6 and divide by 31 (the number of days in the month), for a result of 19 days.
How to improve your accounts receivable turnover
If a company’s ART rate is low, it could be because their collection process isn’t effective, their credit policy isn’t strong enough, their customers aren’t creditworthy, or they’re carrying a lot of bad debt.
Companies that provide materials or services on credit should develop a consistent collection process. The process should outline the steps that the company will take when an accounts receivable debt has not been paid according to the company’s credit terms.
Steps may include contacting the customer, filing a lien, sending the debt to collections, or filing a lawsuit. Developing and writing down these processes will ensure that all customers are treated the same.
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If a company is having trouble collecting debt, they may want to review their credit policy and terms. A generous policy can be good for encouraging sales, but if the company isn’t getting paid, the sales don’t mean much. Credit terms should be clear and concise, and strict enough to encourage early payment.
A company with a low accounts receiveable turnover rate should also look at how they decide which customers to provide credit to. All credit customers should be reviewed for credit worthiness to make sure that the risk is worth the reward. The criteria for issuing credit can’t be too restrictive, however, or sales will suffer. The goal is to find a happy medium.
Another cause of a low turnover rate is bad debt. The company may have several customers who they know aren’t going to pay their bills. Maybe they’ve lost touch or there is a dispute over how much is owed.
If the company is sure that the debts will not be paid, they should be written off, so they no longer affect the accounts receivable balance and turnover rate. An accountant can help with the process of writing off bad debt.
Getting paid faster is the goal
Credit managers and departments are focused on one goal: collecting payments from their customers. Calculating the ART on a regular basis gives these managers the information they need to determine if they’re successful or not. If collections start to slow down — which causes the ART to go down — managers can make changes in their policies or procedures to address this and improve collections.
Protecting payment rights is always the way to go when working in the construction industry. Having a collection policy and following it for every customer will ensure that your company gets paid in a timely fashion.