Loading the player...

What is the 'Receivables Turnover Ratio'

The receivables turnover ratio is an accounting measure used to quantify a firm's effectiveness in extending credit and in collecting debts on that credit. The receivables turnover ratio is an activity ratio measuring how efficiently a firm uses its assets.

Receivables turnover ratio can be calculated by dividing the net value of credit sales during a given period by the average accounts receivable during the same period. Average accounts receivable can be calculated by adding the value of accounts receivable at the beginning of the desired period to their value at the end of the period and dividing the sum by two.

The method for calculating receivables turnover ratio can be represented with the following formula:

Formula for Receivables Turnover Ratio calculated as net credit sales divided by average accounts receivable

The receivables turnover ratio is most often calculated on an annual basis, though it can also be calculated on a quarterly or monthly basis.

Receivable turnover ratio is also often called accounts receivable turnover, the accounts receivable turnover ratio, or the debtor’s turnover ratio.

BREAKING DOWN 'Receivables Turnover Ratio'

In essence, the receivables turnover ratio indicates the efficiency with which a firm collects on the credit it issues to customers. Firms that maintain accounts receivables are indirectly extending interest-free loans to their clients since accounts receivable is money owed without interest. As such, because of the time value of money principle, a firm loses more money the longer it takes to collect on its credit sales.

To provide an example of how to calculate the receivables turnover ratio, suppose that during 2017 Company A had $800,000 in net credit sales. Also suppose that on the first of January it had $64,000 accounts receivable and that on December 31 it had $72,000 accounts receivable. With this information, one could calculate the receivables turnover ratio for 2017 in the following way:

average accounts receivable = ($64,000 + $72,000) / 2 = $68,000

receivables turnover ratio = $800,000 / $68,000 = 11.76

This means that Company A collects its receivables 11.76 times on average per year. This number also serves as an indicator of the number of accounts receivable a company collects during a year. One can determine the average duration of accounts receivable during a given year by dividing 365 by the receivables turnover ratio for that year. For this example, the average accounts receivable turnover is 365 / 11.76 = 31.04 days. The average customer takes 31 days to pay his or her bills. If the company had a 30-day policy for when payments should be made, then the average accounts receivable turnover shows that the average customer makes payments late.

Interpreting 'Receivables Turnover Ratio'

A high receivables turnover ratio can imply a variety of things about a company. It may suggest that a company operates on a cash basis, for example. It may also indicate that the company’s collection of accounts receivable is efficient, and that the company has a high proportion of quality customers that pay off their debts quickly. A high ratio can also suggest that the company has a conservative policy regarding its extension of credit. This can often be a good thing, as this filters out customers who may be more likely to take a long time in paying their debts. On the other hand, a company’s policy may be too conservative if it is too tight in extending credit, which can drive away potential customers and give business to competitors. In this case, a company may want to loosen policies to improve business, even though it may reduce its receivables turnover ratio.

A low ratio, in a similar way, can also suggest a few things about a company, such as that the company may have poor collecting processes, a bad credit policy or none at all, or bad customers or customers with financial difficulty. Theoretically, a low ratio can also often mean that the company has a high amount of cash receivables for collection from its various debtors, should it improve its collection processes. Generally, however, a low ratio implies that the company should reassess its credit policies in order to ensure the timely collection of imparted credit that is not earning interest for the firm.

Uses of 'Receivables Turnover Ratio'

The receivables turnover ratio has several important functions other than simply assessing whether or not a company has issues collecting on credit. Though this offers important insight, it does not tell the whole story. For example, if one were to track a company’s receivables turnover ratio over time, it would say much more about the company’s history with issuing and collecting on credit than a single value can. By looking at the progression, one can determine if the company’s receivables turnover ratio is trending in a certain direction or if there are certain recurring patterns. What is more, by tracking this ratio over time alongside earnings, one may be able to determine whether a company’s credit practices are helping or hurting the company’s bottom line.

While this ratio is useful for tracking a company’s accounts receivable turnover history over time, it may also be used to compare the accounts receivable turnover of multiple companies. If two companies are in the same industry and one has a much higher receivables turnover ratio than the other, it may prove to be the safer investment.

Limitations of 'Receivables Turnover Ratio'

Like any metric attempting to gauge the efficiency of a business, the receivables turnover ratio comes with a set of limitations that are important for any investor to consider before using it.

One important thing to consider is that companies will sometimes use total sales instead of net sales when calculating their ratio, which generally inflates the turnover ratio. While this is not always necessarily meant to be deliberately misleading, one should generally try to ascertain how a company calculates their ratio before accepting it at face value, or otherwise should calculate the ratio independently.

Another important consideration is that accounts receivable can vary dramatically over the course of the year. This means that if one picks a start and end point for calculating the receivables turnover ratio arbitrarily, the ratio may not reflect the true climate of the company’s issuing of and collection on credit. As such, the beginning and ending values selected when calculating the average accounts receivable should be carefully picked so as to represent the year well. In order to account for this, one could take an average of accounts receivable from each month during a twelve-month period.

It is also important to note that comparisons of different companies’ receivables turnover ratios should only be made when the companies are in the same industry, and ideally when they have similar business models and revenue numbers as well. Companies of different sizes may often have very different capital structures, which can greatly influence turnover calculations, and the same is often true of companies in different industries. The receivables turnover ratio is not particularly useful in comparing companies with significant differences in the proportion of sales that are credit, as determining the receivables turnover ratio of a company with a low proportion of credit sales does not indicate much about that company’s cash flow. Comparing such companies with those that have a high proportion of credit sales also does not usually indicate much of importance.

Lastly, a low receivables turnover ratio might not necessarily indicate that the company’s issuing of credit and collecting of debt is lacking. If, for example, distribution messes up and fails to get the right goods to customers, customers may not pay, which would also decrease the company’s receivables turnover ratio.

RELATED TERMS
  1. Overall Turnover

    Overall turnover is a term commonly used in Europe and Asia to ...
  2. Share Turnover

    Share turnover is a measure of stock liquidity, figured by dividing ...
  3. Annual Turnover

    The percentage rate at which a mutual fund or exchange-traded ...
  4. Average Collection Period

    The average collection period is the time it takes for a business ...
  5. Accounts Receivable - AR

    Accounts receivable is the balance of money due to a firm for ...
  6. Inventory Turnover

    Inventory turnover is a ratio showing how many times a company ...
Related Articles
  1. Investing

    Reading The Inventory Turnover

    Inventory turnover is a ratio that shows how quickly a company uses up its supply of goods over a given time frame. Inventory turnover may be calculated as the market value of sales divided by ...
  2. Investing

    Measuring Company Efficiency To Maximize Profits

    Efficiency ratios can provide indications of profitability, shows how efficiently a company is being managed, utilizes its assets and handles liabilities.
  3. Investing

    Operating Performance Ratios

    Learn about the fixed-asset turnover, sales/revenue per employee, operating cycle and dividend payout ratio.
  4. Trading

    Seven Emerging Currencies Challenging The Forex Hierarchy

    While the top-seven currencies follow a somewhat stable hierarchy, second-tier currencies can be all over the map.
  5. Investing

    Ford's 4 Key Financial Ratios (F)

    Learn about Ford Motor Company and how to analyze its business using financial ratios that help assess leverage, operations and profitability.
  6. Investing

    Ford Vs. Dodge: Comparing Under the Hood (F, FCAU)

    Explore the recent financial performance of Ford Motor Company and Dodge's parent company, Fiat Chrysler, comparing growth, profits, efficiency and outlook.
  7. Investing

    Mutual Fund Due Diligence: 5 Things to Look Out for in Quarterly Reports

    Learn about five important items found in a mutual fund's annual and quarterly reports and why investors should pay attention to changes in these items.
RELATED FAQS
  1. What do efficiency ratios measure?

    Learn about efficiency ratios, what they measure, how to calculate commonly used efficiency ratios and how to interpret these ... Read Answer >>
  2. How should I use portfolio turnover to evaluate a mutual fund?

    Learn about the turnover rate for mutual funds, and understand the effect higher turnover may have on fund performance and ... Read Answer >>
  3. Can a company's working capital turnover ratio be negative?

    Learn how the working capital turnover ratio turns negative as a result of a company's negative working capital when current ... Read Answer >>
  4. How can a company raise its asset turnover ratio?

    Find out more about the asset turnover ratio, what it measures, how to calculate the ratio and how a company could increase ... Read Answer >>
  5. What does a high inventory turnover tell investors about a company?

    Inventory turnover is an important metric for evaluating how efficiently a firm turns its inventory into sales. Read Answer >>
  6. Why are efficiency ratios important to investors?

    Learn about efficiency ratios, such as the asset turnover ratio, and why these metrics are important to investors when analyzing ... Read Answer >>
Trading Center