The quicker your business is able to collect on outstanding invoices, the healthier it will be financially. It’s better for cash flow purposes and saves money and headaches associated with trying to collect delinquent debts.
The AR turnover ratio is a standard metric used to determine the pace with which businesses are able to collect their debts. It isn’t difficult to compute and knowing your company’s ratio will give you a benchmark against which you can judge attempts to collect invoices more rapidly.
How To Compute Your Business’s Accounts Receivable Turnover Ratio
To compute this ratio you’ll need to know your company’s net credit sales and your average accounts receivable. These numbers are available on your company’s balance sheet.
To compute this ratio you’ll divide your net credit sales by your average AR. Here’s a bit more information on these two measures.
Net Credit Sales
This is the portion of your annual sales that are tied up in invoices. To compute your net credit sales you’ll take your total annual sales and subtract any cash sales, sales returns, and other allowances, such as price changes and discounts.
Average Accounts Receivable
This represents the average amount of money owed to your business as invoices at any given time. You’ll compute this by adding your accounts receivable amount from the beginning of the year to the amount from the end of the year. Then you’ll divide by two.
Let’s say you had $20,000 in AR at the start of the year and $35,000 at the end.
$20,000 + $35,000 = $55,000
$55,000 ÷ 2 = $27,500
This shows that your average AR is $27,500 for the year.
Computing Your Accounts Receivable Turnover Ratio
$150,000 ÷ $27,500 = 5.45
Your accounts receivable turnover ratio is 5.45. This means that your AR turned over 5.45 times in the last year. To put that in terms that are easier to understand, divide the total number of days in the year by your ratio.
365 ÷ 5.45 = 66.9
This tells you that it took an average of about 67 days for you to collect on an invoice. To collect invoices faster, you need a higher ratio. As an example, had you found your ratio was double what it is, or 10.9, you would know that you’re collecting invoices in half the time, or in 34 days.
Now that you know your AR turnover ratio, what can you do to improve it?
Improving Your Accounts Receivable Turnover Ratio
A low AR turnover ratio can indicate poor collections policies and/or a larger than ideal percentage of financially irresponsible customers. For the health of your business, you should try to increase low ratios. Here are a few things to try.
In order to collect payments quickly, it’s best to invoice while your work is still fresh in your customer’s mind. Send out invoices as soon as the work is completed. This shows you’re serious about your credit collection policies.
Include Early Payment Discounts and Late Payment Penalties
You can offer a small discount to entice customers to pay their invoices earlier than required. You might also charge a penalty for late payments beyond a certain point. If your terms are normally net 30, you might offer a 3% discount for payments made within 15 days.
Penalties shouldn’t be onerous. You don’t want to punish your customers. You only want to motivate them to pay. 1.5% interest per month that the invoice is late might be appropriate.
Give Your Customers a Range of Payment Options
Let your customers pay you however they see fit. This helps their payment processes and can get you paid faster. Offer links to online payment options directly within your invoice and also allow for credit card payments, checks, bank drafts, and more.
Take Deposits Upfront
An upfront deposit ensures that you’ll receive at least some portion of your total invoice. A deposit also gets your customer to put skin in the game, which increases the likelihood that the remainder will be paid on time.
Send Out Regular Reminders
Use an automated invoicing system to send automatic emails when your customers become delinquent. Oftentimes a friendly reminder is all it takes to get paid.
Stop Working With Problematic Customers
Customers that pay egregiously late on a regular basis will drag down your AR turnover ratio and cause constant problems for your business. Consider whether you might be better off not working with them.
The longer invoices remain unpaid, the longer your business can’t use that money to pay its own bills. Try these suggestions to get your AR turnover ratio higher. Your business will thank you.
The turnover ratio is a measure of current liabilities and an indicator of a low collections model.
If the ratio is too high, means a business has very aggressive collections practices, which may drive new customers or even loyal customers to the competition.
Finally, it’s good to keep records of different ratios over different periods (months, quarters, etc) so the business can adjust its collections practices accordingly.