Companies that maintain accounts receivables are essentially providing interest-free loans to their clients - accounts receivable is money owed without interest for the set term, which is often a 30 or 60 day period the client has to pay for the product.
The account receivables turnover ratio (ART ratio) is used to measure a company's effectiveness in collecting its receivables or money owed by clients. The ratio shows how well a company uses and manages the credit it extends to customers, and provides a number for how quickly that short-term debt is paid. This number can be calculated on a monthly, quarterly or annual basis.
How to calculate ART ratio?
To calculate the ART ratio, you need to choose what period of time your measuring and know the beginning accounts receivables for the period, and the ending accounts receivables for the period. The formula looks like this:
- Beginning accounts receivable + ending accounts receivable / 2 = net accounts receivable
- Net credit sales / net accounts receivable = accounts receivable turnover
The Smith Company has a beginning accounts receivable of $250,000 and an ending accounts receivable of $315,000. Their net credit sales is $3.8 million.
- $250,000 + $315,000 = $565,000 / 2 = $282,500
- Step 2: $3,800,000 / $282,500 = 13.45
The Smith Company has an accounts receivable turnover of 13.45.
What is a good ART ratio?
The ART ratio alone may not be meaningful, as every industry is different and each business has its own terms for customer accounts. Therefore it’s important to look at it in context of other information, which will help you assess how well the AR and collections process is working.
The first way to assess your ART ratio is to look at it in terms of other periods. If you calculate it monthly, how has the number adjusted month over month? If you calculate it quarterly, compare the past few quarters. You may be aware of certain spikes or changes in your business that impact the ART, and being able to account for that as you look at how the ratio shifts will give you an indication of whether or not your AR and collections process is performing well.
Another way to assess how your AR process is working is to look at competitors. For example, if investors were interested in the Smith Company, they might look at the Smith Company’s ART as it compares to their closest competitors. If the Jones Company has a higher ART ratio than the Smith Company, then the Jones Company might be a safer investment.
It is also useful to look at the actual number of days it takes to collect the receivables. This gives you the average for whether your customers are actually paying within the terms you’ve set. The formula is 365 days divided by the ART ratio. So for the Smith Company:
- 365 days per year/13.45 ART = 27 days
If the Smith Company has a 30-day payment policy, then their average number of days for payment falls within their policy window.
High vs. Low Ratios
A high receivables turnover ratio can indicate that a company’s collection of accounts receivable is efficient and they have reliable customers who pay their debts quickly. A high receivables turnover ratio might also indicate that a company operates on a cash basis, or has a conservative credit policy.
A low receivables turnover ratio can suggest the business has a poor collection process, bad credit policies, or customers that are not financially viable or creditworthy. Typically, a company with a low ART ratio should reassess its credit policies to ensure the timely collection of its receivables.
Keep in mind, there are some limitations with the ART ratio. One is to clarify if the calculation is being made with total sales instead of net sales. Using total sales inflates the results. Another limitation is that accounts receivables can vary dramatically throughout the year. For example, seasonal businesses will have periods with high receivables along with a low turnover ratio and then fewer receivables which can be more easily managed and collected.
Understanding the business cycles and processes is key to making smart use of the ART ratio. As a standalone metric it will not provide much value, but when you consider it within the overall context of the business, and the market, it can shed light on areas for improvement in our AR process, as well as highlight where your team is performing well.