What is Account Receivable Turnover?
Definition: The accounts receivable turnover is defined as the efficiency ratio used to measure how efficiently a company is collecting accounts receivable. Account Receivable turnover is the ratio of the average accounts receivable of a period divided by the net credit sales of the same period.
Accounts receivable turnover is the number of times a company collects its average accounts receivable in an accounting period. This ratio represents how effectively a company is managing its collection from debtors. If the collections are managed by a business properly, the cash flow becomes more predictable, and the balance sheet looks healthier. The higher accounts receivable turnover ratio indicates the faster collection of its receivables.
This ratio is essential for businesses when it comes to taking credit. The account receivable turnover gives a complete idea of how efficiently a company collects its debts against the credit extended by them. This ratio is also known as the debtor’s turnover ratio.
Understanding Accounts Receivable Turnover Ratio
The accounts receivable turnover ratio comes into play in business accounting for quantifying how adeptly companies are managing the credit that they had offered to their customers by gauging how much time will it take to collect the outstanding debt in an accounting period.
For instance, if a company ABC supplies its goods to different stores across the USA and then sends invoices to each of them once every month. The payment term for each of the customers is net30 which means payment is due thirty days after the date of the invoice. Now, some customers would pay on time as per the term while few of those will go out and not pay anything to ABC. While on the other hand, in another example, if a cable TV company XYZ offers Cable TV services to its consumers. All their customers are billed a month in advance to prevent any customer from receiving Cable TV services without paying the bill.
Hence, it is clear that company XYZ protects its accounts receivables better than ABC, as XYZ would disconnect the service before the next credit is offered to the customer. All in all, you need to understand here that the accounts receivable turnover ratio will let you know how long it will take your consumers to pay on average.
This information will ultimately help you in understanding a lot about how financially stable your company is and how well managed its cash flow is.
Account Receivable Turnover Ratio Formula
The formula to calculate the accounts receivable turnover ratio is
Accounts Receivable Turnover Ratio= Net Credit Sales / Average Accounts Receivable
- Net credit sales= Sales on credit – Sales returns – Sales Allowances
- Average accounts receivable= (Opening Accounts Receivable + Closing Accounts Receivable) / 2
The above-calculated ratio can be converted in terms of days. When a company wants to interpret the results of this ratio in days, they can convert this into days.
Accounts Receivable Turnover in Days
The accounts receivable turnover in days shows that the average number of days it takes a customer to pay the debt amount to the company against the credit purchase. The formula for calculating the same is:
Accounts Receivable Turnover in days = 365/ Accounts Receivable turnover ratio
Example for Turnover Ratio Accounts Receivable
Suppose ABC Shop is a retail store that sells furniture. Due to the declining sales, the shop owner decides to extend the credit sales for all the customers. In the fiscal year ending on December 31, 2020, there were INR 100,000 gross credit sales and returns of INR 20,000. The opening accounts receivable of the shop were INR 15,000, and closing accounts receivable were INR 5,000. Now, the owner wants to know how many times the store has collected its account receivable in this financial year. Therefore, here the calculation of the accounts receivable turnover ratio can meet this need of the owner. The following can be the calculation for the same:
Account Receivable Turnover Ratio = (INR 100,000 – INR 20,000) / ((15,000 + 5,000)/2) = 8
This ratio shows that ABC shop collected its average accounts receivable approximately eight times over the fiscal year.
If, in any case, the same has to be calculated in days, then the calculation will be:
Account Receivable Turnover in days= 365/8= 45.625
This means that the average customer takes approximately 46 days to pay their debt to the store. If the store has a 30-day credit policy, then this receivable turnover in days shows that the average customer makes a late payment.
Interpretation of Receivable Turnover Ratio Accounts
As mentioned above, Accounts Receivable turnover shows that how efficiently a company collects its credit amount from customers. This ratio also indicates the company’s financial and operational performance. If a company has a high receivable turnover ratio, then this indicates that the company’s collection of accounts receivable is frequent and efficient. It also indicates that the company has a high-quality customer base that pays the debts quickly or on time. This high ratio also indicates that the company has extended a short credit period which can be maybe 20 days or ten days.
But if a company has a low account receivable ratio, then it shows that the collection process of the company is lacking. This can happen because of the company’s extending credit terms to non-creditworthy customers. It can also indicate that the company’s extending credit policy is for an extended period. The low account receivable ratio is considered detrimental to a company.
For a company, it is better to compare the ratio with that of its competitors in the industry. With this comparison, a company can make a meaningful analysis and takes steps accordingly.
Problems Associated with Ratio Accounts Receivable Turnover
The following points must be considered by a company when they are calculating account receivable turnover ratio:
1. The use of total sales in place of net credit sales can give misleading measurement if the proportion of cash sales are high.
2. During the calculation of turnover ratio, only the beginning and ending balances are considered. But these amounts may vary considerably from the average amount during the fiscal year. Therefore, it is recommended to use other methods for arriving at the average accounts receivable amount.
3. A low account receivable turnover may not cause because of the fault of the credit or collection staff. It can be possible because of the errors made in other parts of the company.
On the concluding note, it is clear that the accounts receivable turnover ratio is an efficiency ratio that helps businesses in measuring the number of times a company collects its average accounts receivable in a particular accounting period.
It is good for a business to have a high turnover ratio as it ensures that the collection process of the company is efficient, plus its customer base is also of high quality. It also suggests that the company incorporates a conservative credit policy.
On the contrary, low accounts receivable turnover ratio is considered harmful for businesses, as it indicates a poor collection process that will ultimately extend the credit terms to bad customers, or it may extend its credit policy for too long.
Now, after understanding the whole concept, what will your definition of accounts receivable turnover ratio?