A very important concept for a business of any size is accounts receivable -- or the balance of money due for goods or services sold to customers that have not yet been paid for. Accounts receivable is considered a form of credit because the company doesn’t get the cash upfront for the customer’s purchase. On a company balance sheet, accounts receivables are listed as current assets. Closely related to accounts receivable is what’s called the accounts receivable turnover ratio, which is significant to measuring a company’s performance. Read on to find out what accounts receivable ratio is and how to calculate it for your business.
Before defining what accounts receivable turnover ratio is, it’s best to define what an efficiency ratio is. An efficiency ratio is used to measure how well a company is utilizing its assets and resources. Accounts receivable turnover ratio is a type of efficiency ratio that measures how many times a business can turn its accounts receivable into cash during a given period. Put another way, the accounts receivable turnover ratio measures how many times a business can collect its average accounts receivable during the year. On a broader level, the accounts receivable turnover ratio shows how well a company uses and manages the credit it extends to its customers and clients, as well as how quickly that short-term debt is collected or is paid.
To calculate the accounts receivable turnover ratio, divide net credit sales by the average accounts receivable for that period. Net credit sales are used instead of net sales because cash sales don’t create receivables. Only credit sales create a receivable, which is why cash sales are excluded from the calculation. The concept of net sales is pretty straightforward, referring to sales minus returns and refunded sales. The accounts receivable turnover ratio formula looks like this: Account receivables turnover ratio = Net credit sales / Average accounts receivable
See: 6 Invoice Factoring Options for Your Business Often, you can find a business’s net credit sales in the company’s income statement for the year. However, not all companies report cash and credit sales separately. A further step you can take once you have the accounts receivable turnover ratio is determining the accounts receivable turnover in days. The formula is as follows: Receivable turnover in days = 365 / Receivable turnover ratio This shows the average number of days that it takes a customer to pay your company for sales on credit. Below, you’ll find a table that breaks down an example for calculating the accounts receivable turnover ratio and receivable turnover in days based on a simplified income statement for a hypothetical business.
Income Statement and Accounts Receivable Turnover
Year Ended Dec. 31, 2020
Gross credit sales
Credit sales returns
Credit sales allowances
Accounts receivable, beginning of Year
Accounts receivable, end of Year
Accounts receivable turnover ratio
Receivable Turnover in Days
Learn: 6 Invoicing Best Practices for Small and Midsize Businesses For this company, the accounts receivable turnover ratio is 8.75. This means that Company ABC collected its average accounts receivable roughly 8.75 times over the fiscal year ending Dec. 31, 2020. What’s more, based on the receivable turnover in days determined here, the average customer takes just under 42 days to pay their debt to the store — the purchase they made on credit. Here is the formula for accounts receivable turnover ratio spelled out in more detail: Account receivables turnover ratio = Net credit sales / Average accounts receivable
Subtracting $10,000 in credit sales returns from $150,000 in total credit sales results in net credit sales of $140,000. You take this net credit sales number and divide it by the average accounts receivable — the accounts receivable at the beginning of the year plus end of the year divided by two — to arrive at 8.75 for your accounts receivable turnover ratio. To then get receivable turnover in days, all you have to do is take 365 and divide by 8.75 to get 41.71 days. Read Next: 7 Best Business Line of Credit Options
It is desirable to have a high accounts receivable turnover ratio since this ratio measures a business’s ability to efficiently collect its receivables. Having a higher accounts receivable turnover ratio means that your company is collecting its receivables more frequently throughout the year. For example, a ratio of three means that your company collected its average receivables three times during the year. Put another way, your company collects its money from customers every four months. If the ratio is 12, it would indicate that your company is collecting its average receivables 12 times a year, equivalent to collecting money from customers every month. Having a low accounts receivable turnover ratio, on the other hand, implies your company is less efficient in collecting its receivables. Doing a poor job of collecting money from customers and clients can stem from extending credit terms to noncreditworthy customers or those who are experiencing financial troubles. Another reason for a low ratio is that your company could be extending its credit terms for too long — perhaps even beyond net-90 days. The problem with an overly long credit policy is that, the longer a company takes to collect on its credit sales, the less value comes from the company’s sales. In effect, the company is losing money.
Your company’s accounts receivable turnover ratio is both very useful and very telling about your business. All businesses need to be efficient , and the accounts receivable turnover ratio is one of the key efficiency ratios used to measure a company’s ability to utilize its assets and resources. If you work out the accounts receivable turnover ratio for your business and find it on the low-side, your company is likely weak in collecting credit sales. When this happens, it can lead to cash flow issues, which may require you to take out additional loans or find working capital financing to bridge any gaps. To maintain a high accounts receivable turnover ratio, only extend credit to creditworthy customers and clients. Also, stick with conservative due dates for credit payments, such as net-10, net-20 or net-30 days. Being too generous with your credit terms may inflate sales numbers on paper. But if it takes you forever to collect, you’re only losing out on money. More From Seek
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