Accounts Receivable Turnover

What is Accounts Receivable Turnover?

Accounts Receivable Turnover Ratio is an efficiency ratio which indicates how times a company is able to collect its average receivables in a given period. Providing a line of credit is one thing, but collecting this ‘interest-free loan’ from the debtors is another.

Accounts Receivable Turnover ratio estimates a firm’s effectiveness with which it collects the credit from its debtors.

Calculate Accounts Receivable Turnover Ratio

Accounts Receivable Turnover ratio is calculated by dividing the net credit sales with by the average accounts receivable. 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)
• Net Credit Sales = Gross Credit Sales – Returns (or Refunds)

Accounts Receivable Turnover Example

Suppose, in the year 2010 a company had a gross credit sale of $1000,000 and $200,000 worth of returns. On the 1^st of January 2010, the accounts receivable were $300,000 and that on 31^st 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
• Accounts Receivable Turnover Ratio = 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.

Interpretation of Accounts Receivable Turnover Ratio

• Usually, the higher turnover ratio is preferred as it indicates the company’s efficiency to collect its receivables.
• A higher ratio means that the company is collecting cash more frequently and/or has a good quality of debtors. This 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 ratios of two companies in the same industry.

 

Precautions While Using Accounts Receivable Turnover Ratio

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 sales. This can be misleading if attention is not paid.

Also as stated above, the average accounts receivable turnover are calculated by taking only the first and last months into consideration. This 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.

Recommended Articles

This has been a guide to Accounts Receivables Turnover Ratio. Here we discuss accounts receivables turnover ratio calculation, its interpretation along with practical examples of Colgate and its comparables. You may also refer to the following articles to learn more about Financial Ratios.

• Is Accounts Receivable an Asset?
• Accounts Receivable–Debit or Credit?
• Accounts Receivable Journal Entry
• Financial Ratios Formula
• Uses of Ratio Analysis
• Accounts Receivables Factoring
• Allowance for Doubtful Accounts
• Write-Off
• Liquid Assets