Cash flow is king when it comes to business. One metric that gets overlooked but has huge power in determining your cash flow is the accounts receivable turnover ratio. This isn’t just for accountants; it’s for business owners, managers and investors who want to understand the financial efficiency of a company.
Cash Flow Stagnation
You run a mid-sized manufacturing company. You have contracts with several big retailers and business should be booming. But despite healthy sales numbers you’re struggling to pay your suppliers on time. You’re constantly juggling payments and at times even dipping into your line of credit to pay payroll. What’s going on?
In many cases the root cause of cash flow problems isn’t lack of sales but the speed at which you’re getting paid for those sales. If customers take too long to pay your cash flow suffers and that can lead to all sorts of problems including strained relationships with suppliers, increased debt and missed opportunities for growth.
The Accounts Receivable (AR) Turnover ratio is a metric that shows you how fast you’re collecting from your customers. Low turnover means customers are taking their time to pay and high turnover means they’re paying fast. Understanding and improving this ratio will change your cash flow and make your business more robust and ready to pounce on opportunities as they come.
The Cost of Poor Accounts Receivable Management
Now let’s get a little agitated. Your accounts receivable turnover is slow. What’s the big deal? You’re still making sales, right?
Case Study: XYZ Distribution Inc.
XYZ Distribution Inc., a wholesale distributor of consumer electronics, was in a bind despite steady sales growth. For fiscal year 2023, their sales had grown 20%. But their cash reserves were dwindling and they were consistently late on payments to suppliers. Upon further review, the problem was clear: their accounts receivable turnover had dropped from 9 to 6 in the last year.
What does this mean? In simple terms, their customers were paying slower. The company was collecting its average receivables every 60 days instead of every 40 days. That 20 day delay in cash flow resulted in a $2 million reduction in working capital and XYZ had to take on short-term debt to cover their operational expenses. The interest on that debt was eating into their profits and suppliers were starting to demand upfront payments because of late payments.
The result? XYZ’s profit margins shrunk and their growth slowed down. And to make matters worse, they missed out on bulk purchase discounts because they couldn’t pay suppliers on time. This isn’t unique to XYZ; it’s a reality for many businesses that don’t keep a close eye on their accounts receivable turnover.
Facts:
- XYZ Distribution Inc.’s accounts receivable turnover ratio dropped from 9 to 6, meaning customers were taking 20 days longer to pay their invoices.
- $2 million reduction in working capital due to slower receivables resulted in more borrowing and interest costs, reducing profitability.
- Solution: Boost Your Accounts Receivable Turnover
So how do you avoid XYZ’s fate? The answer is to boost your accounts receivable turnover. Let’s get into it.
Step 1: Calculate Your Current AR Turnover
First calculate your current accounts receivable turnover. The formula is simple:
Accounts Receivable Turnover=Net Credit SalesAverage Accounts Receivable
For example, if your net credit sales are $1 million and your average accounts receivable over the period is $200,000, your AR turnover ratio would be 5. So you’re collecting receivables 5 times a year.
Step 2: Set Payment Terms
Make sure your payment terms are clear and communicated to your customers. Standard terms are “Net 30” meaning payment is due within 30 days. But depending on your industry and customer relationships you might consider shorter terms like “Net 15” to speed up collections.
Step 3: Offer Early Payment Incentives
Another way to improve your turnover ratio is to offer early payment discounts. For example a 2% discount for payments made within 10 days (2/10, Net 30) can speed up payments and improve your cash flow.
Step 4: Improve Invoicing and Follow-Up
Invoicing is key. Send invoices promptly and follow up on overdue payments immediately. Automated invoicing software can help streamline this process and get you paid faster.
Step 5: Check Customer Creditworthiness
Not all sales are good sales. Extending credit to customers who are late payers or have bad credit is risky. Review your customers creditworthiness regularly and adjust their credit limits accordingly.
Step 6: Monitor and Adjust
Monitor your accounts receivable turnover regularly. A dip can mean cash flow issues. Adjust as needed to keep your turnover healthy.
FAQs
Q1: What’s a good accounts receivable turnover?
A: It varies by industry but generally the higher the better. It means you’re collecting your receivables efficiently. For most industries 7-12 is considered good.
Q2: How do I improve my accounts receivable turnover?
A: Set clear payment terms, offer early payment discounts, streamline your invoicing process and review your customers creditworthiness regularly.
Q3: What are the risks of low accounts receivable turnover?
A: Low AR turnover can lead to cash flow problems, higher borrowing costs, supplier issues and missed opportunities.
Bottom line
In business it’s easy to get caught up in chasing sales. But as we’ve seen making the sale is only half the battle. Converting sales into cash is just as important. Keep an eye on your accounts receivable turnover and take action to improve it and you’ll have a steady cash flow to support your business growth and stability. Don’t be another cash flow case study—act now.
