Home Plumbing Contractor Free Plumbing and Heating Contractor Business Strategy Questionnaire 8.5 Accounts Recievable Turnover Ratio Analysis Questionnaire
What is the AR Turnover Ratio and how why is it included in a business plan for a Plumbing and Heating Contractor?
The Accounts Receivable (AR) Turnover Ratio in a business plan for a small business like Central Plumbing & Heating Inc. measures the number of times the sales of a company have turned over the accounts recievable of the company. In other words it measures the number of times the accounts receivable of a small business like Central Plumbing & Heating Inc. is collected during an year. Clearly the more times the accounts receivable are turned over in an year, the better it is for the firm since it shows that either the sales of the company are very healthy and /or that the accounts receivables are very low and that most customers are paying promptly. As a general rule the higher the AR turnover ratio the better it is for the business.
What does it mean if the AR Turnover Ratio is low? Should that be a cause for concern for a business owner like Felix Gonzalez?
Yes. As a general rule a low AR turnover implies that the collection of the firm are not doing well. We have often seen this take place even in the most successful and established businesses like tax preparation, where the back office is not very diligent in following up with clients who have not paid their bills resulting in substantial outstanding receivables and a low AR turnover ratio.
Many small business owners don't like to pursue their receivables aggressively because they are always afraid of losing their customer to the competition if they are too aggressive in their collections. This tends to be the case when the start up a new business and they are never quite able to change that practice when their business gets well established and as a result they have to finance their business by using lines of credit or other sources of financing during times of a cash flow crunch. What small business owners like Felix Gonzalez have to understand is that by having a large amount of uncollected cash, they are in fact losing money. That money that should be in their checking and savings account collecting interest or being invested, is instead still in the bank accounts of the folks that owe them the receivable and they are benefiting from it!
Asking a client to pay you what they owe you is not only the right thing to do - it is also good business practice. A well established rule in business is that the longer you take to get your accounts receivables paid to you, the lesser are the chances that you will ever get paid. The reason for this may not be that the clients does not intend to pay, but because of the ever changing needs and demands that the business world places on them, they may well not have the ability to pay you back as time progresses. Make sure you collect!
Can an aggressive receivables collection policy hurt a small business like Central Plumbing & Heating Inc.?
Like all other things in business, balance is very important. We have seen many businesses try and be flexible with their largest or best customers or those customers with whom they have been doing business for a long time. This of course is regarded simply as good business practice. Large repeat customers expect to be able to pay you over time and you will have to determine for yourself if you want to pursue the collections differently than you would from your regular customers.
It is however important to note that a customer that routinely asks for easy payment terms may be in financial distress and not be able to pay you your money back. This is where a ratio like the Accounts Receivable (AR) turnover comes into play. If you find that an AR turnover of 15 leaves you short on cash many times during the year, then you will have to get more aggressive with your collections policy and improve that turnover ratio giving you more cash to deal with your own cash flow needs.
Can the Accounts Receivable (AR) Turnover ratio affect the competitiveness of a small business like Central Plumbing & Heating Inc.?
Yes. Having a low AR Turnover ratio compared to your competitors can certainly affect a small business like Central Plumbing & Heating Inc. negatively. A lower AR Turnover ratio for Central Plumbing & Heating Inc. implies that it is not collecting its outstanding receivables from its customers as well as its competitors. This of course means that the business is not collecting as much cash as its competitors and when a slowdown or crunch comes up, it will have a much tougher time riding out the storm. Having a lower AR turnover ratio for a dental office for example means that they will have to keep on dipping into their line of credit to meet their working capital needs and sometimes their checks may bounce.
If that pattern were to continue and checks to other vendors and staff were to keep on being returned by the bank, it could negatively affect the ability of the business to get better terms from its vendors and also to hire and retain good employees. In our consultations we have come across many businesses that lost employees to the competition because they were not able to pay them in a timely manner. Having sufficient cash to meet your obligations is key for a small business owner like Felix Gonzalez and having a high AR turnover ratio is an excellent way to monitor and ensure that your collections are well within normal ranges.
Generally, if we see a small business with more than 5% of its annual sales outstanding in receivables implying an AR turnover ratio of 20 or lower, we flag that to be a problem. Thus if your small business has annual sales of $300,000, you should try and keep your receivables to under $15,000 at any given time. This of course is a general rule of thumb and each business owner will have to determine their AR policy based on their own unique business siutation.
Can Accounts Recievable (AR) turnover ratio fluctuate over time for a small business like Central Plumbing & Heating Inc.?
Yes it can and it does. The AR turnover ratio of course depends on the Sales and the Account Receivable, both of which will fluctuate during the year. What we recommend to business owners is that they should be more aggressive with their collections during the slower months where they know that the company will have slower sales and they will need the cash much more than during the good months when sales are fine and having a slightly higher AR turnover ratio won't hurt as much.
Some businesses by their very nature do not have very high or any accounts receivable - for example the restaurant business rarely has any accounts receivables - you eat - you pay! On the other hand manufacturing and distribution businesses often have to extend very generous collection terms to their customers and tend to have lower AR turnover ratio as a result.
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