Managing cash flow is vital for business success. After all, it’s considered the lifeblood of any organization.
However, as your accounts receivable (AR) increases, your cash flow generally decreases. As such, the rate at which your business converts accounts receivable to cash can have a significant impact on operations.
Measuring this conversion can be done with the accounts receivable turnover (ART) ratio. Your ART calculates the number of times your business collects its average accounts receivable balance. In other words, it’s a reflection of how effective your finance team is at collecting outstanding balances from clients, and managing their credit processes.
Usually, the higher your ART, the more efficient your business is at collections. This, in turn, is essential for cash flow and forecasting.
Understanding Accounts Receivable Turnover
In addition to reflecting your business’ effectiveness at collections, the accounts receivable turnover ratio measures how many times your receivables are converted to cash in a certain period of time. This can be monthly, quarterly, or annual.
Your ART is the relationship between net credit sales and average accounts receivable.
It can be calculated with the following formula:
ART = net credit sales / average AR
Net credit sales refers to the amount of revenue earned by your company, which is paid via credit, over a set time period. The average accounts receivable balance is that obtained between your starting accounts receivable balance and ending accounts receivable balance over the same time period. Effectively, this means that the ratio is also a reflection of your company’s liquidity.
For example, say your business had net credit sales of $4 million over the last year, with an average AR of $400,000. By dividing your net credit sales ($4 million) by the average AR ($400,000), you get a ratio of 10. This indicates that your AR turned over ten times in the last year, or once every 36.5 days.
What these ratios indicate
A high accounts receivable turnover ratio indicates that you have a high proportion of customers who pay their debts quickly, or that your finance team is very effective at collections. It might also indicate that your company has conservative credit policies.
Low ratios reflect the opposite; your company has inadequate collection policies, bad credit policies, or customers who don’t pay on time. Despite this, low ratios can be fixed. For example, you could implement new collection procedures and policies to increase the ratio, and get an influx of cash from old receivables.
Whether your company’s ratio is low or high, there are a few key things it indicates. These include:
- Collateral. Some lenders may use accounts receivable as collateral to borrow funds – as such, the higher the ratio, the stronger your collateral.
- Cash flow and liquidity. By knowing your turnover ratio, you can easily predict future cash flow for purchases.
- Market performance. Comparing your ART to those of your competitors can help you benchmark your progress.
- Credit policy assessment. The ratio will help you identify ‘the sweet spot’ for extending a line of credit to your customers.
What makes a good ratio?
As stated, the higher your accounts receivable turnover ratio, the better. However, the ideal ratio depends on your firm. For instance, a ratio of 12 means you collect once a month. Generally, this is excellent for a service-based company. However, businesses like retailers, that need to collect revenue more often, would need a higher ratio for continued success.
Industry-specific dynamics can also affect how the ART is interpreted. For example, different market conditions and customer behaviors can influence benchmark values. As such, when using ART for competitor analysis, always ensure that you only use competitors within your specific industry.
Overall, a faster accounts receivable turnover effectively means that your business will have a quicker cash inflow. This means improved overall liquidity and financial stability.
The Relationship Between Receivables Turnover and Liquidity
Liquidity refers to how efficiently or easily your business can convert an asset into cash, without affecting its market price. The more liquid an asset is, the easier it is to convert to cash. Therefore, cash is considered the most liquid of all a company’s assets.
Generally, liquidity can be calculated using the quick ratio (AKA acid test ratio), which indicates your company’s short-term liquidity ability to meet obligations. In other words, it tracks how quickly you can use near-cash assets to pay liabilities.
It’s calculated as follows:
Quick Ratio= Quick Assets / Current Liabilities
Quick assets, in this instance, encompass cash equivalents, marketable securities, and net accounts receivable. As such, a high accounts receivable turnover effectively means more quick assets, and better liquidity. This, in turn, is usually an indicator of financial health. Indeed, high liquidity offers your business numerous benefits, such as increased flexibility and improved creditworthiness.
How to improve liquidity
You can improve your business liquidity by cutting costs and increasing profits. Below are a few straight-forward considerations to do this.
- Increase your sales (or consider different business models, like subscriptions).
- Reduce overheads (like insurance premiums or office supplies) and operating costs.
- Pay off any debts swiftly, or re-finance them from short-term to long-term debt.
- Sell any liquid assets.
- Improve your collection processes.
For further advice about increasing your business’ liquidity, speak to one of our CPAs.
Strategies for Leveraging ART for Improved Cash Flow
Because a higher accounts receivable turnover means a better cash flow, it’s important to improve your ratio. Thankfully, there are several ways to do this.
- Improve collection processes. By tightening your credit policies, enhancing invoice management through automation, and employing effective collection strategies, your finance team can improve collections.
- Conduct thorough credit assessments. When offering a line of credit to customers, ensure that you have done in-depth credit assessments, considering their payment history and financial stability.
- Make use of technology. Accounting software like QuickBooks and NetSuite can streamline and automate several financial processes, including invoicing and customer reminders, to ensure better AR performance.
- Seek expert advice. When it comes to accounts receivable, having a CPA or legal expert on hand can help you navigate the minefield of collections. After all, these professionals can advise you on best practices, to ensure that you can improve your ART and liquidity.
For help to improve your turnover ratio, or manage your AR, schedule a Discovery Call with one of our CPAs.
The information presented in this blog article is provided for informational purposes only. The information does not constitute legal, accounting, tax advice, or other professional services. We make no representations or warranties of any kind, express or implied, about the completeness, accuracy, reliability, suitability, or availability of the information contained herein. Use the information at your own risk. We disclaim all liability for any actions taken or not taken based on the contents of this blog. The use or interpretation of this information is solely at your discretion. For full guidance, consult with qualified professionals in the relevant fields.
