Accounts receivable turnover is the number of times per year that a business collects its average accounts receivable. The ratio is intended to evaluate the ability of a company to efficiently issue credit to its customers and collect funds from them in a timely manner. A high turnover ratio indicates a combination of a conservative credit policy and an aggressive collections department, as well as a number of high-quality customers. A low turnover ratio represents an opportunity to collect excessively old accounts receivable that are unnecessarily tying up working capital. Low receivable turnover may be caused by a loose or nonexistent credit policy, an inadequate collections function, and/or a large proportion of customers having financial difficulties. It is also quite likely that a low turnover level indicates an excessive amount of bad debt.
Accounts receivable turnover is calculated by dividing net credit sales by the average accounts receivable for that period.
Accounts Receivable turnover ratio : Net Credit Sales / Average Accounts Receivable
The reason net credit sales are used instead of net sales is that cash sales don’t create receivables. Only credit sales establish a receivable, so the cash sales are left out of the calculation. Net sales simply refers to sales minus returns and refunded sales.
The net credit sales can usually be found on the company’s income statement for the year although not all companies report cash and credit sales separately. Average receivables is calculated by adding the beginning and ending receivables for the year and dividing by two. In a sense, ther is a rough calculation of the average receivables for the year.
Since the receivables turnover ratio measures a business’ ability to efficiently collect its receivables, it only makes sense that a higher ratio would be more favorable. Higher ratios mean that companies are collecting their receivables more frequently throughout the year. For instance, a ratio of 2 means that the company collected its average receivables twice during the year. In other words, the company is collecting is money from customers every six months.
Higher efficiency is favorable from a cash flow standpoint as well. If a company can collect cash from customers sooner, it will be able to use that cash to pay bills and other obligations sooner.
Accounts receivable turnover also is and indication of the quality of credit sales and receivables. A company with a higher ratio shows that credit sales are more likely to be collected than a company with a lower ratio. Since accounts receivable are often posted as collateral for loans, quality of receivables is important.
Whether the accounts receivable turnover ratio of 10 is good or bad depends on the company’s past ratios, the average for other companies in the same industry, and by the specific credit terms given to ther company’s customers.
It is important to note that the accounts receivable turnover ratio is an average, and averages can hide important details. For example, some past due receivables could be “hidden” or offset by receivables that have paid faster than the average. If you have access to the company’s details, you should review a detailed aging of accounts receivable to detect slow paying accounts.
Krystal’s Electronics Shop is a retail store that sells Electronics. Krystal offers accounts to all of her main customers. At the end of the year, Krystal’s balance sheet shows $20,000 in accounts receivable, $75,000 of gross credit sales, and $25,000 of returns. Last year’s balance sheet showed $10,000 of accounts receivable.
The first thing we need to do in order to calculate Krystal turnover is to calculate net credit sales and average accounts receivable. Net credit sales equals gross credit sales minus returns (75,000 – 25,000 = 50,000). Average accounts receivable can be calculated by averaging beginning and ending accounts receivable balances ((10,000 + 20,000) / 2 = 15,000).
Finally, Krystal’s accounts receivable turnover ratio for the year can be like this.
AR Turnover Ratio : $50,000 / $15000 = 3.3
As you can see, Krystal’s turnover is 3.33. This means that Bill collects her receivables about 3.3 times a year or once every 110 days. In other words, when Bill makes a credit sale, it will take him 110 days to collect the cash from that sale.