Why Is the Accounts Receivable Turnover Ratio Important?

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The Accounts Receivable Turnover Ratio is crucial because it measures how efficiently a company collects payments from its credit sales. This ratio provides insights into a company's cash flow management and credit policies.Importance of the Accounts Receivable Turnover Ratio:

• Cash Flow Efficiency: A higher ratio indicates faster collection of receivables, leading to improved cash flow and financial stability.
• Credit Policy Assessment: It helps evaluate the effectiveness of credit policies and collection processes. A high ratio suggests efficient credit management, while a low ratio may indicate issues with collections.
• Financial Health Indicator: The ratio is used by lenders and investors to assess a company’s creditworthiness and operational efficiency, impacting funding opportunities and growth potential.

• Benchmarking: Comparing the ratio against industry standards helps identify areas for improvement and ensures alignment with best practices.

Overall, the Accounts Receivable Turnover Ratio is a key metric for understanding and optimizing a company's financial performance.

What Are Some Examples of Accounts Receivable Turnover Ratio?

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Here are practical examples to illustrate how the Accounts Receivable Turnover Ratio works:Example 1: Manufacturing Company

• Net Credit Sales: ₹20,00,000
• Average Accounts Receivable: ₹3,50,000
• Turnover Ratio = 20,00,000 ÷ 3,50,000 = 5.71
  This ratio indicates the company collects its receivables about 5.71 times per year.

Example 2: Retail Business

• Net Credit Sales: ₹4,00,000
• Average Accounts Receivable: ₹35,000
• Turnover Ratio = 4,00,000 ÷ 35,000 = 11.43
  This higher ratio suggests more efficient collection practices, typical for retail businesses.

Industry Benchmarks

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Different industries have varying typical ratios:

• Retail: 10-15 times per year
• Manufacturing: 5-10 times per year
• Service Industry: 5-12 times per year

A higher ratio generally indicates better collection efficiency, while a lower ratio might suggest the need for improved credit policies or collection procedures1.

What Is Considered a Good Accounts Receivable Turnover Ratio?

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A higher turnover ratio is considered a good sign for the business.

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However, the value of the accounts receivable turnover ratio is generally determined by comparing to other similar businesses. For example, if a business has a ratio of ten and the average rate for its competitors is five, then they have a much better turnover ratio than the industry average.

What Is the Accounts Receivable Turnover Ratio in Days?

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For further analysis, accountants may use the accounts receivable turnover ratio to calculate another ratio.

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The accounts receivable turnover ratio in days reveals how many days it takes to collect payments.

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It is calculated by dividing the number of days in the accounting period by the turnover ratio.

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In the second example above, if the accounting period under review was for one month, the accounts receivable turnover ratio in days would be calculated by dividing the number of days in the month, 30, by the turnover ratio, 10. The turnover ratio in days would be 3 (30 ÷ 10 = 3).

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This means that it takes three days on average for the business to collect payment on its credit sales.

How Is the Accounts Receivable Turnover Ratio Calculated?

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The Accounts Receivable Turnover Ratio is calculated to assess how efficiently a business collects its outstanding credit sales. It measures how many times, on average, the accounts receivable are collected during a specific period. Here’s how it is calculated:Formula

Accounts Receivable Turnover Ratio=Net Credit SalesAverage Accounts ReceivableAccounts Receivable Turnover Ratio=Average Accounts ReceivableNet Credit Sales​

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Steps to Calculate

1. Determine Net Credit Sales:
   Calculate the total sales made on credit during the period, excluding any returns or allowances.
2. Calculate Average Accounts Receivable:
   Find the average accounts receivable by adding the beginning and ending balances of accounts receivable for the period and dividing by two.
3. Apply the Formula:
   Divide the net credit sales by the average accounts receivable to get the turnover ratio.

Interpretation

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A higher turnover ratio indicates that a company is efficient in collecting its receivables, suggesting strong credit management and cash flow. Conversely, a lower ratio may indicate inefficiencies in collection processes or issues with customer credit policies.