What is Trade Receivables Turnover Ratio & How to Calculate: Formula
Businesses frequently offer customers a time span of credit on a purchase, particularly for large purchases. However, the time it takes to recover payments due from each debtor significantly impacts the overall performance of the business. That is precisely what the accounts receivable or AR turnover ratio indicates.
What Is The Receivable Turnover Ratio?
The receivables turnover ratio, or receivables turnover, is a metric employed in corporate accounting to assess how well companies manage the credit they present to their customers by determining the time it takes to obtain the outstanding debt throughout the accounting period.
Formula For AR Turnover Ratio
The ATR ratio is calculated by dividing total credit sales and the average of AR (accounts receivable).
ATR Ratio = Total Credit Sales (TCS) / ACR (Average of AR)
We have two main components in the above receivables turnover ratio formula:
Net Credit Sales = Gross Credit Sales - Sales Returns. It must be noted that we can't take net sales into account here. We must separate credit from cash sales. Then we must deduct any returns from the credit sales.
Average accounts receivable - To calculate the average accounts receivable, we must consider two components: opening and closing accounts receivable and determine the average of the two.
Raj's Flower Shop provides floral centerpieces for corporate events. The sales are generally made on credit. Credit sales at the shop totalled 10,00,000. At the start of the year, the account receivables were 2,50,000. It was Rs.3,20,000 at the close of the fiscal year.
Based on the data presented above:
Accounts receivable average = (3,20,000+2,50,000) / 2 = 2,85,000
Account Receivables = Total Credit Sales / Average AR
Account Receivables = 10,00,000 / 2,85,000
Account Receivables = 3.51
As a result, the business's accounts receivable were turned over 3.51 times, implying that average receivables were gathered in 103.9 days.
Advantages Of Knowing The Trade Receivables Turnover Ratio And Its Applications
Increased Cash Inflows
The ratio represents the amount of time it takes the company to turn its credit transfers into cash; this allows the company to plan ahead of time and ensures a fast turnaround of credit transfers to cash.
Write-Offs And Bad Debts Are Reduced
Customers' failure to pay their bills frequently results in massive business losses. With the assistance of this ratio, the company can better manage the density of credit sales and provide credit sales to its most dependable and consistent customers, resulting in a reduction in write-offs as well as bad debts.
Stringent Credit Policies
Based on the ART ratio, the company may tighten its current credit policies to avoid issues such as cash shortages or customer payment defaults.
Debt Collection Takes Less Time
As a byproduct of the improved credit policies, the time required to recoup outstanding debt will be reduced accordingly, boosting cash inflows.
Do You Want Your ART To Be Higher Or Lower?
A high ART ratio can signal that the business is cautious when granting credit to its customers and is either efficient or assertive in its collection practices. It may also indicate that the company's customers are of excellent quality and that it operates on a cash basis.
However, only some of these things are necessarily a good thing. If a company is overly cautious in granting credit, it may result in sales lost to competitors or experience a significant drop in sales whenever the economy slows. Businesses must determine if a lower ratio is appropriate to offset difficult times.
On the other hand, a low ratio may imply that a business is poorly run, grants credit too quickly, overspends on operations, serves a financially risky financial client base, or is negatively affected by a broader economic occurrence.
ART Ratio Limitations
The following are some common limitations of the ART ratio:
- The receivables turnover ratio does not consider payment timing.
- The receivables turnover ratio does not consider the creditworthiness of the customers.
- The ART ratio doesn't consider terms of sales.
Tips For Improving ART Ratio
- Examine your credit policy to ensure that it is stringent enough to safeguard your company but not so stringent that it prevents you from making a sale.
- Make sure that you are billing your customers on time and accurately.
- Follow up with the customers who have not paid their invoices on time.
- Provide early payment discounts.
- Consider utilizing a factoring company to fund your receivables.
- Use accounting software that monitors receivables and generates reports on past-due receipts to stay abreast of your collections.
Managing your accounts receivable is essential for enhancing cash flow and determining economic growth and improvement opportunities. Businesses can improve their economic endeavors' efficiency, reputation, and profitability by being vigilant and tenacious in ensuring that unpaid debts are paid promptly.