Definition of Accounts Receivable Turnover Ratio
The accounts receivable turnover ratio is an important financial ratio that indicates a company's ability to collect its accounts receivable. Collecting accounts receivable is critical for a company to pay its obligations when they are due.
The calculation of the accounts receivable turnover ratio is: credit sales for a year divided by the company's average amount of accounts receivable throughout that year. Note that only the company's credit sales (or sales on credit) are used in the calculation, since cash sales do not involve accounts receivable.
Example of Accounts Receivable Turnover Ratio
To illustrate the calculation of the accounts receivable turnover, let's assume that a company’s credit sales for the most recent year were $6,000,000 and its average amount of accounts receivable during that year were $600,000. As a result, the accounts receivable turnover ratio is: credit sales of $6,000,000 divided by the average amount of accounts receivable of $600,000 = 10 times a year. This indicates that on average the company’s accounts receivables turned over 10 times during the year, or approximately every 36 days (360 or 365 days per year divided by the turnover of 10).
Whether the accounts receivable turnover ratio of 10 is good or bad depends on the company's past ratios, the average for other companies in the same industry, and the specific credit terms given to the company's customers.
It is important to emphasize that the accounts receivable turnover ratio is an average, since an average can hide important details. For example, some past due receivables could be "hidden" or offset by receivables that have paid faster than the average. If you have access to the company's details, you should review a detailed aging of accounts receivable to detect slow paying customers.