Accounts Receivable Turnover: Formula, Definition, Using, Example, Explanation

Definition:

Accounts Receivable Turnover is one of the most used efficiency ratios and activities ratios. This ratio is used 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 (like 15 times or 54 days) when receivables are collected per year.

Accounts Receivable Turnover is calculated using Net Credit Sales over the average of accounts receivable outstanding.

This ratio is typically used to measure the performance of cash collection. It is also used with Account Receivable Days to interpret efficiency and activities ratios as more realistic and meaningfully complete.

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:

We will discuss two things here, and the following is 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

Noted:

  • Accounts Receivable Ratio measures the efficiency of the company in controlling its account receivable in terms of collecting activities—number of collections. It is normally used as the key performance indicator for management by the board of directors, especially for a 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.
  • The 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.
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Control Accounts Receivable

There are many reasons you should make sure account receivable collecting activities are proper. Accounts receivable are when your customers purchase goods or render services from your company on credit. AR are the types of loans you provide to them in terms of free of interest.

Once the AR is long outstanding, you lose the free loan’s interest to them, but you also lose interest that you should have gained if you collect and deposit it into the banks.

More importantly, your company will pay additional cash interest expenses to the bank through overdraft if there is a cash shortage.

Most of the shareholders are generally concerned about management performance. They always point to management about the long outstanding account receivables because they show weak internal control in this sensitive area. All of these reasons are the main factors to control Accounts Receivable Turnover.

To help you better understand, let’s move to the examples and calculations below. We will also provide a deep analysis of the result of our estimate.

Example and Calculation:

ABC operates 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, the account receivable is USD 600,000. The sales revenue during the year is USD1,000,000.

Assess the Accounts Receivable Turnover of the company.

Answer:

  • 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. There is a large amount of AR compared to sell, probably 50%.

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This shows that the collection is not good. Management needs to consider setting up the appropriate internal control and process over this to minimize the receivable outstanding.

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 is almost a year. This is clearly showing that the receivable collection is not good.

However, many factors affect the long outstanding of AR, and to make sure that the interpretation is correctly said, additional information might be needed.

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 that lead to long outstanding while the reality does not.

Another implication is that the collection personnel already correct the money from the client, if the collection is mostly by cash, but they don’t bank in cash or submit it to the cashiers.

Another reason and mostly face is that the customers have cash flow difficulty; therefore, they cannot 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 are the acceptable amount of Account Receivable Turnover Ratio as well as how many days.

Conclusion:

The main functions of Account Receivable Turnover Ratio are:

  • Measure the efficient 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
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