How to Calculate Receivables Turnover
Calculate receivables turnover to gain crucial insights into your company's efficiency in collecting payments and managing its credit.
Receivables turnover measures how effectively a business manages credit sales and collects payments. This financial metric evaluates a company’s efficiency in converting accounts receivable into cash. Understanding this calculation provides a clear picture of a company’s ability to manage short-term assets and maintain healthy cash flow.
What Receivables Turnover Means
Receivables turnover is an efficiency ratio that measures how many times a company collects its average accounts receivable balance within a defined period. This ratio assesses the effectiveness of a company’s credit policies and collection procedures. It indicates how quickly a business converts its credit sales into cash.
A higher receivables turnover ratio suggests a company is efficient in collecting outstanding customer balances. This efficiency leads to improved cash flow and reduced risk of uncollectible accounts. Conversely, a lower ratio might signal issues with collections or overly lenient credit terms, potentially straining liquidity.
Gathering the Necessary Financial Figures
To calculate the receivables turnover ratio, two financial figures are needed: net credit sales and average accounts receivable. Net credit sales represent total revenue from credit sales, after accounting for returns, allowances, or discounts. Businesses typically find this information on their income statement. If credit sales are not separately available, total sales can be used as a proxy, though focusing solely on credit sales offers a more precise analysis.
Average accounts receivable is the second component, representing the average balance owed by customers over a specific period. This average smooths out fluctuations in balances. To calculate it, sum the beginning and ending accounts receivable balances, then divide by two. Accounts receivable balances are reported on a company’s balance sheet.
Performing the Receivables Turnover Calculation
With net credit sales and average accounts receivable identified, the receivables turnover calculation uses a straightforward formula. The formula divides net credit sales by the average accounts receivable balance. This division yields a ratio indicating how many times the average accounts receivable was collected during the period.
For example, consider a company with net credit sales of $1,000,000 for the year. If its beginning accounts receivable was $150,000 and its ending accounts receivable was $250,000, the average accounts receivable would be $200,000 (($150,000 + $250,000) / 2). Plugging these figures into the formula, the receivables turnover would be $1,000,000 divided by $200,000, resulting in a ratio of 5.0.
Understanding Your Calculated Ratio
Interpreting the numerical result reveals a company’s collection efficiency. A higher ratio indicates more frequent and efficient collection of accounts receivable. This suggests effective credit policies and diligent collection efforts, contributing positively to cash flow and financial stability. It may also imply customers are settling invoices promptly.
Conversely, a lower receivables turnover ratio signals issues with a company’s credit and collection practices. This might suggest customers are taking longer to pay, or the company has extended overly generous credit terms. A persistently low ratio could lead to cash flow shortages and an increased risk of bad debts. The ratio’s meaning is best understood when compared against industry benchmarks or the company’s own historical performance. Different industries have varying collection cycles, so what is efficient in one sector might be less so in another.
Calculating Days Sales Outstanding
Days Sales Outstanding (DSO) is a complementary metric used alongside receivables turnover to assess collection efficiency. DSO measures the average number of days it takes for a company to collect payments after a sale. It offers a time-based perspective on the collection process, making efficiency more tangible.
To calculate DSO, divide the number of days in the period (typically 365 for a year) by the receivables turnover ratio. Using the previous example where receivables turnover was 5.0, the DSO would be 365 days divided by 5.0, resulting in 73 days. A lower DSO figure is preferred, as it indicates quicker cash collection, enhancing liquidity and operational flexibility.