Accounts Receivable Turnover Ratio Meaning
The accounts receivable turnover ratio indicates how effectively a business collects credit from its debtors. It is calculated by determining how frequently a business collects its average accounts receivable over a specified time period.
A higher accounts receivable turnover ratio is desirable since it indicates a shorter time delay between credit sales and cash received. On the other hand, a lower turnover is detrimental to a business because it shows a longer time interval between credit sales and cash receipts. Additionally, there is always the possibility of not recovering the payment.
Providing a line of credit is one thing, but collecting this ‘interest-free loan’ from the debtors is another.
Accounts Receivable Turnover Formula
Accounts Receivable Turnover is calculated by dividing the net credit sales with the average accounts receivableAccounts ReceivableAccounts receivables refer to the amount due on the customers for the credit sales of the products or services made by the company to them. It appears as a current asset in the corporate balance sheet.. It is to be noted that net credit sales are considered instead of net sales, the reason being that net sales include cash sales as well, but cash sales do not fall under credit sales.
Accounts Receivable Turnover Ratio Formula = (Net Credit Sales) / (Average Accounts Receivable)
In the above ratio, we have two components.
- Net Credit Sales = Gross Credit Sales – Returns (or Refunds). We need to keep in mind that here we can’t take the total net sales. We need to separate the cash sales and credit sales. And then, we need to deduct any sales return related to the credit sales from the credit sales.
- Average accounts receivables – To find out the average accounts receivables (net), we need to consider two elements – Accounts Receivables (Opening) Accounts Receivables (Closing) and find the average of the two.
Suppose, in the year 2010 a company had a gross credit sale of $1000,000 and $200,000 worth of returns. On the 1st of January 2010, the accounts receivable were $300,000 and that on 31st December 2010 were $ 500,000
Based on the above information:
- Average Accounts Receivable = (3,00,000 + 5,00,000) / 2 = Rs. 4,00,000
- Net Credit Sales = 10,00,000 – 2,00,000 = 8,00,000
- Receivable Turnover = 8,00,000 / 4,00,000 = 2
Form the above example, the turnover ratio is 2, which means that the company is able to collect its receivables twice in the given year or once in 182 days (365/2).
In other words, when a credit sale is made, it will take the company 182 days to collect the cash from the sale.
- A higher ratio means that the company is collecting cash more frequently and/or has a good quality of debtors. It, in turn, means the company has a better cash position, indicating that it can pay off its bills and other obligations sooner. Many times, the accounts receivable turnover are posted as collateral for loans, making a good turnover ratio essential.
- At the same time, a high turnover ratio may also mean that the company transacts mainly in cash or has a strict credit policy.
- A lower ratio may mean that either the company is less efficient in collecting the creditor, has a lenient credit policy, or has a poor quality of debtors.
- Looking at just the number (turnover ratio) doesn’t give the complete picture. It is better to check for the turnover ratio trends over the years to assess the true collecting efficiency of the companies. Many prudent analysts analyze if the company’s ratio is affecting its earnings. It is also useful to compare the turnover ratiosCompare The Turnover RatiosTurnover Ratios are the efficiency ratios that measure how a business optimally utilizes its assets to generate sales from them. You can determine its formula as per the Turnover type, i.e., Inventory Turnover, Receivables Turnover, Capital Employed Turnover, Working Capital Turnover, Asset Turnover, & Accounts Payable Turnover. of two companies in the same industry.
Accounts Receivables Turnover of Colgate
- Now that we have seen how to calculate the asset turnover ratio let us see how the turnover ratio is for Colgate.
- We have assumed here that all the Sales on Colgate’s Income statement is Credit Sales.
- The following image shows the calculation of average receivables turnover of 2014 and 2015
- Colgate’s accounts receivables turnover has been high at around 10x for the past 5-6 years.
- Higher Turnover implies a higher frequency of converting receivables into cash.
How is Colgate accounts receivables turnover ratio as compared to P&G and Unilever?
- We note that P&G Receivable turnover ratio of around 13.56x is higher than that of Colgate (~10x)
- Unilever’s Receivables turnover is closer to that of Colgate.
As an investor, care should be taken how the company has calculated the turnover ratio. Many firms consider gross credit sales rather than net credit salesNet Credit SalesNet credit sales is the revenue generated from goods or services sold on credit excluding the sales discount, sales allowance and sales return. It even amounts to the accounts receivables for a certain accounting period.. It can be misleading if attention is not paid.
Also, as stated above, the average receivable turnover are calculated by taking only the first and last months into consideration. It may not give the correct picture if the accounts receivables turnover has drastically varied over the year. To overcome this shortcoming, one can take the average over the whole year, i.e., 12 months instead of 2.
Accounts Receivable Turnover Video
This article has been a guide to Accounts Receivables Turnover Ratio. Here we discuss its formula, calculations, interpretation along with examples. You may also refer to the following articles to learn more about Financial Ratios.