One of the many useful metrics in tracking your financials that many small businesses may not have a handle on is your Accounts Receivable Turnover. Simply put, Accounts Receivable Turnover is the ratio of net credit sales over average accounts receivable in a given period: a measure of how effective your business is at extending trade credit and collecting that debt from customers.
It’s important to remember that the A/R turnover ratio is an average. Just like your Accounts Receivable balance, your A/R Turn fluctuates over time. Generally speaking, if your A/R Turnover is high, then your credit policies and collection practices are working to your company’s benefit. Alternatively, if your A/R turn is low, then your cash flow may suffer as a result and your policies may need improvement.
What affects A/R Turn?
If your A/R Turn changes from month to month, there are two logical reasons:
- a change in credit policy where your terms change (e.g. you may extend a customer 45 day terms rather than 30 day terms). All else equal, the longer credit terms you give your customer, the lower your A/R Turn will be.
- A change in collections practices. The faster you collect your Accounts Receivable, the higher your turn will be. Conversely, if you do not have an active collections program, then payments from customers may be delayed resulting in a lower A/R Turn.
Generally an increase in A/R Turn is a good thing; however, a decreasing A/R Turn – or one that is low to begin with – is a big red flag for cash flow issues.
How to use it
Accounts Receivable Turnover is most useful when it is looked at as an ongoing trend, rather than a snapshot of one particular period. You can track A/R Turn from year to year, quarter to quarter, month to month, etc; like any financial metric, the more you review and analyze it, the more effective you will be in managing your cash flow.
What can be done?
If your net credit sales are increasing, that’s widely considered a good thing; that shows your company is growing. However, if your A/R turn is decreasing, it may be a sign that changes need to be made or your cash flow could suffer dramatically. Growing sales at the expense of collecting Accounts Receivable is a dangerous path to follow. Many small business owners will think business is booming as sales increase, but will be puzzled when they are constantly running out of cash each month. Cash flow is the lifeblood of every growing business so it’s important to manage Accounts Receivable Turnover.
Many companies will offer discounts to customers to pay early. If it’s not possible to require shorter credit terms, then a better structured collections practice may be the solution. However, sometimes change isn’t possible or there’s just no more room for improvement. Perhaps the only way to score that next big contract is to offer terms that let your customer take longer to pay. Or you may not want to risk losing a customer by being more demanding in your collections management.
If your cash flow is sufficient to qualify for a bank line of credit, you can use those funds to help supplement any cash flow issues. If you are having cash flow constraints but have strong Accounts Receivable, then you can turn those to your advantage with Accounts Receivable Financing or an Asset-Based Line of Credit. Whether utilizing Accounts Receivable Financing, an Asset-Based Line of Credit or traditional Factoring, you can leverage your Accounts Receivable to improve your cash flow and the overall health of your business; these products are all aimed at exactly the problem presented by a low/decreasing A/R Turnover.