Accounts Receivable Turnover is one of the most uses of efficiency ratios as well as activities ratios. This ratio is using to measure how efficiently the company’s assets and resources are managed and used.
For example, how well the company turns its accounts receivable into cash? This ratio answers this question in time or days (like 15 times or 54 days) that receivables are collected per year.
Accounts Receivable Turnover is calculated by using Net Credit Sales over the average of accounts receivable outstanding.
This ratio normally uses to measure the performance of cash collection and It is also used with Account Receivable Days so that the interpretation of efficiency and activities ratios are more realistic and meaning full.
Pls: Understanding all aspect and element in the formula is very importance to help you get the right understanding about this ratio.
Accounts Receivable Turnover Formula:
There are two things we will discuss here and the following are their formula.
- Accounts Receivable Turnover Ratio = Net of Credit Sale / Average of Account Receivable
- Accounts Receivable Days = [365 *Average of Account Receivable] / [Net of Credit Sale
- Accounts Receivable Ratio measures the efficiency of the company in controlling its account receivable in terms of collecting activities—number of collections. It normally uses as the key performance indicator for management by the board of directors especially for the company that faces financial difficulty. The higher the ratio, the weak performance in AR management.
- Account Receivable Days measure the average period that AR are collected.
- Average of Account Receivable here is normally the average of the beginning of AR and ending accounting receivables. However, if the beginning of AR is not found or provided, use the ending balance.
Control Accounts Receivable
There are many reasons why you should have to make sure account receivable collecting activities are proper.
Accounts receivable are happening when your customers purchased goods or rendered services from your company on credit. AR are the types of loans that you provide to them in terms of free of interest.
Once the AR is long outstanding, you not only lose the free loan’s interest to them, but you also lost interest that you should have gained if you collect and deposit into the banks.
More importantly, your company will pay additional cash interest expenses to the bank through overdraft in case there is a cash shortage.
Most of the shareholders normally concern about management performance and always point to management about the long outstanding account receivables, because it shows the weak internal control on this sensitive area. All of these reasons are the main factors to control Accounts Receivable Turnover.
To help you get a better understanding, let move to the examples and calculations below. We will also provide a deep analysis of the result of our calculation.
Example and Calculation:
ABC is operating in the service industry by providing law consultant services to commercial companies.
At the beginning of the year, ABC’s Account Receivable Outstanding is USD 500,000 and at the end of the current year, account receivable is USD 600,000. The sales revenue during the year is USD1,000,000.
Assess the Accounts Receivable Turnover of the company.
- Account Receivable Turnover Ratio = 1,000,000/[(500,000+600,000)/2] = 1.8
- Account Receivable Days = 365/ 1.8 = 203 days
Accounts Receivable Turnover in Performance Management and Interpretation
Based on the calculation above, we noted that the Account Receivable Turnover is 1.8, and this ratio represents the collective of its AR, and there is a large amount of AR compare to sell, probably 50%.
This shows to us that the collection is not good and management needs to consider setting up the appropriate internal control and process over this to make sure that the receivable outstanding is minimize.
Remember that long outstanding account receivable is the cost to the company.
Now we look at the account receivable days. As per calculation, AR days are 203 days and it almost year. This is clearly showing that the receivable collection is not good.
However, there are many factors that affect the long outstanding of AR, and to make sure that the interpretation is correctly said, additional information might be need.
For example, the industry average, competitors’ performance in this area, and the previous year’s performance. Probably, there are some problems with the accounting recognition for revenues and account receivables lead to long outstanding while the reality does not.
Another implication is that the collection personals already correct the money from the client, if the collection is mostly by cash, but they don’t bank in the cash or submit to the cashiers.
Another reason and mostly face is that the customers have the cash flow difficulty, therefore, they are not able to pay, or they would like to delay payment.
To control its liquidity and resources, management might need to set the performance measurement for these ratios; for example, how much is the acceptable amount of Account Receivable Turnover Ratio as well as how many days.
Main functions of Account Receivable Turnover Ratio are:
- Measure the efficiency use of the company’s assets, especially accounts receivable.
- Assess the performance of credit sales and cash collection of sales and collection function
- Setting up the performance measurements for management in controlling cash flow and working capital.
- Helping management in setting up credit sales policies
- Helping management in setting cash collection policies