Before I going to explain Accounts Receivable Turnover Ratio, let me explain the efficiency ratio first.
Efficiency Ratios
Efficiency ratios measure the capability of a business to use its assets and liabilities to generate sales. A very well-organized business has decreased its net investment in assets, and so needs less capital and debt in order to remain in operation.
- In the case of liabilities, the main efficiency ratio compares payables to total purchases from suppliers.
- In the case of assets, efficiency ratios compare combined set of assets to sales or the cost of goods sold.
The efficiency divided into following:
- Accounts Receivable Turnover
- Asset Turnover Ratio
- Total Asset Turnover Ratio
- Inventory Turnover
- Days’ sales in Inventory
Accounts Receivable Turnover Ratio:
What does the accounts receivable turnover ratio measure? here is the answer to your question.
Accounts receivable turnover ratio is an efficiency ratio and it is also called activity ratio. The accounts receivable turnover ratio measures how many times a business can collect its average accounts receivable during the year period.
We can also say that account receivable turnover ratio measures how many times a business can turn its accounts receivable into cash during the year period.
How to calculate accounts receivable turnover ratio:
Below is the formula and example that elaborate you that how you can calculate account receivable turnover ratio.
Accounts Receivables Turnover Ratio Formula:
The accounts receivable turnover ratio is computed by dividing net credit sales by the average accounts receivable for that period.
Here point to be noted that we should take Net Credit Sales and not Net Sales because the cash sales does not the receivable only credit sales establish a receivable.
Net sales is only sales minus returns and refunded sales.
The net credit sales can generally be found on the company’s income statement for the year although not all companies report cash and credit sales separately. Let take this example of TOYO Co had $40,000 of average receivables during the year and collected $80,000 of receivables during the year, the company would have turned its accounts receivable twice because it collected twice the amount of average receivables.
This ratio shows how well-organized a company is at collecting its credit sales from its customers. Some businesses collect their receivables from their customers in 90 days while other proceeds up to 6 months to collect from customers.
In some ways the receivables turnover ratio can be viewed as a liquidity ratio as well. Companies are more liquid the quicker they can convert their receivables into cash.
Accounts Receivables Turnover Ratio Example
At the end of the year, TOYO Co balance sheet shows $40,000 in accounts receivable, $150,000 of gross credit sales, and $50,000 of returns. Previous year’s balance sheet showed $20,000 of accounts receivable.
In order to measure the turnover ratio we calculate net credit sales and average accounts receivable. Net credit sales equals gross credit sales minus returns (150,000 –50,000 = 100,000). Average accounts receivable can be calculated by averaging beginning and ending accounts receivable balances ((20,000 + 40,000) / 2 = 30,000).
To conclude, TOYO Co accounts receivable turnover ratio for the year can be like this.
Here we calculate the TOYO Co turnover ratio that is 3.33. It means that TOYO Co collects his receivables about 3.3 times a year or once every 110 days. We can say, when TOYO Co makes a credit sale, it will take him 110 days to collect the cash from that sale.
Accounts Receivables Turnover Ratio Scrutiny/Analysis / Interpretation
A higher ratio would be more favorable & good accounts receivable turnover ratio. A high accounts receivable turnover ratio indicates that companies are collecting their receivables more frequently throughout the year. For example, a ratio of 2 means that the company collected its average receivables twice during the year.
We can say, this business is collecting its money from customers every six months.
From a cash flow standpoint higher efficiency is favorable. If a business can collect cash from customers faster, it will be able to use that cash to pay bills and other liabilities quicker.
Downloads:
- Accounts receivable turnover ratio calculator
