Accounts Receivable Turnover is the efficiency ratio that directly measures the performance of receivable collecting activities over the year.
It uses to analyze the number of times that net credit sales during the period are collected based on the relationship between net credit sales during the period and averaged accounts receivable at the end of the period.
The high AR turnover ratio suggests many positive things that indicate the entity has well managed its AR. For example, the credit policy is good, and collection procedures are well performed.
High turnover generally assumes to be well performed. However, a small ratio means there are large AR at the end of the period, and it is assumed to be bad performance in term of collection.
The following are the details of the Accounts Receivable Turnover Ratio Analysis that deeply analyze the factors that affect the ratio, including credit policy, collection procedure, nature of business, and the importance of this ratio.
Understand the Formula:
Before going into detail, let start with the element that we use to calculate this ratio. The first important element is the Net Credit Sales.
This is the total sales that the entity sells on credit during the year by excluding the sales that customers made by cash. It depends on the nature of business and customers’ behavior.
In some businesses, the customer made the payment by cash when purchasing, and in some businesses, sales on credit mostly happen.
Another important element to calculate this ratio is Account Receivable. For calculation, we use averages of AR. That means we take the average of the opening balance of AR at the beginning of the year and the ending balance of it at the end of the year.
In some cases, the business starts, and the period is shorter than one year. In this case, the beginning is zero. We can use the ending balance for calculation.
Well, many factors affect the ratio to jump up and down. And it might not work because of the performance of the collection. Here are the factors that you should consider when performing Accounts Receivable Turnover analysis:
- Larges credit sales transactions at the end of the period: As well know, some business, there are larges sales transactions at the year-end. If those sales are on credit and during the credit period, the customers are not required to pay yet. This factor will highly affect the ratio. And nothing involved with the performance of the collection.
- Poor credit assessment. It is based on company policies. Some companies have proper credit policies and required proper credit assessment. Then, all credit sales are properly collected, and there is a small bad debt. However, for some companies, there are poor credit policies and control. The sales officers try to forces sales performance by careless on customer’s diligence and finally affect the collection performance. No matter how good collecting performance is, they’re still large credit sales uncollected.
Fraud case over receivable collection. This is probably the most important one when you perform Accounts Receivable Turnover analysis. First, the large AR might be because AR is collected, but cash is kept with collecting or sales officers.
That means in accounting records, AR still outstanding. Second, the fraud might be committed by the management team try to manipulate the fake sales transactions at the end of the period to meet the sales performance and then create the sales return in the next period. This case also creates AR large outstanding during the period and finally leads to a low ratio.
Written by Sinra