Accounts Receivable Turnover Explained

When you are considering buying a company, investing in shares of stock, or wanting to know how viable your own company is then accounts receivable turnover is an important factor. The accounts receivable turnover ratio of a company can give you a good idea of the general cash flow of the company. Companies with weak accounts receivable turnover ratios often have difficult times maintaining positive cash flow. Without positive cash flow, companies usually find themselves in situations where it is difficult to survive financially. A good picture of the overall health of a company can be seen looking at the company's accounts receivable turnover ratio.

Keep in mind that Accounts Receivables of the company are only realized into cash once they are received. If they are not collected then it will greatly impact the cash position of the company.

What is accounts receivable turnover?

A company's accounts receivable are the sales of that company's services or products. Accounts receivable refers to the balances owing on invoices procured for sales of the company's services or products. Companies that do not operate on a cash basis generally provide services or products and then invoice for them. During the period from which the company has performed a service or provided a product until that service or product has been paid for by the customer, the account is considered receivable. In effect these customers are now operating on loan terms. The company has put up the money required to produce the goods or services and the customer has to repay them. Accounts receivable turnover relates the amount of outstanding invoices, or "loans" the company has provided, to the amount of sales for any given period. This relationship provides the accounts receivable turnover ratio.

What is the accounts receivable turnover ratio?

The equation for the accounts receivable turnover ratio is:

Net Credit Sales/Accounts Receivable = Accounts Receivable Turnover

While the net credit sales for the company may provide valuable information, net credit sales alone cannot show a prospective buyer or investor the true picture of health of the company. By assessing the net credit sales in terms of the accounts receivable, a better idea of the cash flow of the company can be determined.

What is the significance of the accounts receivable turnover ratio?

A high accounts receivable turnover ratio is an indication that the company's accounts receivable collection policies are effective. This shows that the company is consistently receiving payment for services or goods produced in a timely manner. The flow of cash out of and into the company is balancing and, if the prices are set correctly, the company should be netting a profit.

A low accounts receivable turnover ratio shows that the company is not effectively collecting payments for services or products. This not only shows that the company could be experiencing cash flow difficulties and may not be generating a profit but, also could be an indication that the company is not being properly managed.

Solutions for a low accounts receivable turnover ratio:

If your company is experiencing a low accounts receivable turnover ratio, then you need to make some changes to your collection policies. First you should consider revising your payment terms. If it is possible to accept cash for goods or services, begin requiring payment at time of receipt. If this is not possible, lower your terms for penalty late fees. Sometimes when customers see that they will incur a late fee if payment is not made promptly, they will be more inclined to pay when payment is due. Finally, step up your collection efforts for current accounts receivable. Your company provided services or products, the customer should be held responsible for payment. Make phone calls; send letters and overdue invoices regularly. Keep a close eye on your company's accounts receivable turnover ratio. The difference between a high and low ratio could mean the difference in consistently turning a profit.

Understanding the basic terms in accounting will help you fully understand the results of operation of a certain business entity. There are many accounting ratios and formulas that you can utilize in order to analyze if a company is performing well or not.

The Finance Profession studies these kinds of analysis to know the company's profitability. If you want to venture into this profession, understanding the Accountant Job Description is a great way to find out if you are qualified to become an accounting personnel. It is a high paying job so if you have any experience in Accounting and love to be with numbers, then give it a try.