What Is Accounts Receivable? How to Calculate AR Turnover

Accounts receivable, sometimes shortened to AR, is the amount of money that customers owe a company for goods or services they purchased on credit. Receivables are essentially an IOU—a signed debt acknowledgment document—that a business extends to customers on fixed terms, who are then legally obligated to pay it in full by a predetermined, short-term due date.

Accountants keep track of the owed income from accounts receivable using the current assets section of a company’s balance sheet. When a sale is made on credit in the accrual method of accounting—the most popular type of accounting—an accountant will make a journal entry to credit the sales account and debit the accounts receivable account. When the payment is received, the opposite action occurs—the AR account is credited, and the sales account is debited.

Companies do not pay income taxes on their accounts receivable, but it is considered revenue that factors into its taxable profit. Revenue is listed on the income statement.

When managed well, accounts receivable offer many benefits, like increased sales, customer loyalty, and fewer transactions. However, unpaid invoices from accounts receivable can become a liability with a range of consequences if managed incorrectly. From tying up working capital that can’t be invested into other parts of the business to driving a business to take out loans to meet obligations because of late customer payments and lax credit terms, weak accounts receivable processes can be bad for business.

Some common ways that a business can manage accounts receivables are by setting clear and firm payment terms and accurate and timely invoicing. Additionally, regular bookkeeping with attention to key metrics, such as the accounts receivable turnover ratio to measure efficiency, and using accounting software with automation tools can be helpful.

Here are some types of accounts receivable to illustrate the different ways to use this accounting system:

1. 1. All customers: Some businesses, like utility companies, rely heavily on accounts receivable and make it available to all customers. For example, an electricity company gives each customer its product—electricity—and then charges them and receives payment at the end of the month.
2. 2. Special customers: Some businesses only allow accounts receivable for outstanding and loyal customers who receive periodic invoices instead of paying each transaction. A consumer-facing business, like a dry cleaner or restaurant, might offer this to long-term, high-frequency customers. A restaurant might offer them to reliable purveyors.
3. 3. Notes receivable: Notes receivable is a more formal kind of accounts receivable in which a customer signs a note agreeing to pay back their debts. This promissory note gives the business holding it extra insurance that they will receive payment.

Using a simple financial ratio calculation to determine the AR turnover rate—net annual credit sales divided by average accounts receivables—can give business owners a sense of their liquidity and how quickly and reliably their customers are paying their outstanding invoices. A high ratio reflects a business with frequent and efficient collections and a sound customer base. A low ratio indicates faulty management, credit policies, and customers. Here’s what you need to know to calculate your accounts receivable turnover ratio:

• Calculate your average balance. Add up the beginning and ending receivables from a designated period. Next, divide that number by two. The dividend is your average accounts receivable. For example, Company A’s account receivables began the quarter at $1,000 and ended the quarter at $1,500. The average accounts receivable is $1,250, according to the provided equation.
• Calculate net annual credit sales. Next, determine your net annual credit sales, or the total amount of money paid after the initial sale. Calculate this number by the number of sales returns and sales allowances from the total sum of sales on credit. For example, Company A’s gross credit sales that quarter were $5,000 with no returns.
• Divide the net annual credit sales by the average account receivables. Take the net annual credit sales and divide by the average accounts receivable balance to calculate your turnover ratio. For example, Company A’s receivable turnover ratio would be $5,000 divided by $1,250. Therefore, Company A collected its average accounts receivable approximately four times that quarter.
• Make it a regular part of your accounting process. Repeat this equation multiple times throughout the year to map any changes in your AR turnover ratio. Monitoring this number over time is a good performance indicator. Benching this number against the competition’s numbers will also provide meaningful insight.

Accounts payable and accounts receivable are two accounting systems with some overlap and key differences. Accounts receivable refers to the amount of money customers owe a business firm for a good or service. Conversely, accounts payable is a current liability account that tracks the amount of money a business owner owes a supplier or creditor, which are considered liabilities.

For example, a restaurant that orders a supply of lettuce from a local farm on credit for $500 would record $500 in the accounts payable section of their ledger. In contrast, the local farm would record $500 in the accounts receivable section of their ledger.

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