How Is the Accounts Receivable Turnover Ratio Computed?

The accounts receivable turnover ratio assesses how efficiently a company collects its credit sales. This ratio provides insight into a business’s credit and collection policies, showing how quickly outstanding customer credit converts into cash.

Understanding the Ratio’s Purpose

This ratio evaluates a company’s efficiency in managing credit and collecting customer payments. It serves as an indicator of how quickly accounts receivable are converted into cash, which directly impacts a company’s liquidity and cash flow. A higher turnover generally suggests effective collection practices, while a lower turnover may point to inefficiencies or potential issues with collecting outstanding debts. Tracking this ratio allows businesses to monitor cash flow trends and identify areas for improvement in their credit and collection strategies.

Identifying the Key Components

Net Credit Sales and Average Accounts Receivable are the two figures required to compute the accounts receivable turnover ratio. Net Credit Sales represent the total revenue from sales made on credit, after subtracting any sales returns, allowances, and discounts. This figure excludes cash sales, as they do not generate accounts receivable.

Average Accounts Receivable is the average amount of money owed to the company by its customers over a specific period. It is calculated by taking the sum of the accounts receivable balance at the beginning of the period and the balance at the end of the period, then dividing by two. This averaging helps smooth out any short-term fluctuations in the accounts receivable balance, providing a more representative figure for the period.

Locating the Necessary Financial Data

To find Net Credit Sales, refer to a company’s Income Statement. While the income statement usually shows total sales, a business must isolate the portion that was made on credit. If cash sales are not separately recorded, an estimation might be necessary by subtracting cash received from total sales. Net credit sales are derived by deducting sales returns, allowances, and discounts from the gross credit sales.

For Accounts Receivable balances, consult the company’s Balance Sheet. To compute Average Accounts Receivable, retrieve the accounts receivable balance from two consecutive balance sheets, typically the beginning and ending balances of the reporting period. Sum these two balances and divide the result by two to arrive at the average.

Performing the Calculation

The formula for the accounts receivable turnover ratio is Net Credit Sales divided by Average Accounts Receivable. This quantifies how many times a company collects its accounts receivable balance during a specific period.

For example, assume a company had Net Credit Sales of $800,000 for the year. At the beginning of the year, its Accounts Receivable balance was $90,000, and at the end of the year, it was $110,000. First, calculate the Average Accounts Receivable: ($90,000 + $110,000) / 2 = $100,000. Next, apply the turnover ratio formula: $800,000 (Net Credit Sales) / $100,000 (Average Accounts Receivable) = 8.0 times. This indicates the company collected its average accounts receivable 8.0 times during the year.

What the Result Reveals

The accounts receivable turnover ratio provides insights into a company’s financial health and operational efficiency. A high ratio indicates that a company is efficient at collecting outstanding payments from customers and manages its credit effectively. This suggests a strong cash flow and that customers are paying their invoices promptly. It can also imply conservative credit policies or a high-quality customer base.

Conversely, a low accounts receivable turnover ratio suggests inefficiencies in collections or potential issues with credit management. This could mean customers are taking a long time to pay, or the company might be extending credit to customers who pose a higher credit risk. Interpretation of the ratio should always consider industry benchmarks and the company’s specific business model.