Financial ratios are metrics related to a business or company’s financial statements. These ratios allow stakeholders to gain meaningful information about operations and other aspects. Usually, these metrics involve calculating the relative magnitude of two metrics obtained from the financial statements. In accounting, several accounting ratios provide better insights into a company.
Financial ratios are highly crucial for stakeholders, particularly investors and shareholders. Managers within firms also use these ratios to evaluate internal operations. Stakeholders can use various types of financial ratios that explore several aspects of a business. These include liquidity, profitability, efficiency, and market value ratios.
Within the liquidity ratios, three metrics are prevalent. These include the quick, current, and cash ratios. However, several other liquidity ratios also provide critical information about how efficient companies run. Within these, one ratio is the accounts receivable to sales ratio. Before discussing that, however, it is crucial to understand what liquidity ratios are.
What are Liquidity Ratios?
Liquidity ratios are a group of financial ratios that help measure a company’s liquidity position. These ratios allow stakeholders to gauge a company’s ability to pay off its debts when due. Usually, these metrics provide a better view of a company’s working capital management. Therefore, these ratios consider a company’s current assets and current liabilities for calculation.
Liquidity ratios also measure how quickly a company converts its current assets into cash. The quicker this process happens, the faster companies can pay off their debts. Usually, liquidity ratios and short-term solvency relate to or complement each other. These ratios measure a company’s ability to pay debt obligations and its margin of safety.
As mentioned, stakeholders generally prefer three liquidity ratios. These include the current, quick and cash ratios. All three of these consider a company’s current assets and current liabilities and the contrast between them. Usually, the current liabilities form the denominator for the equation for these ratios. On the other hand, the liquid ratios become the numerator.
Overall, liquidity ratios help stakeholders calculate a company’s financial position. These ratios consider how quickly a company converts its current liabilities into current assets. Through this, they can measure their ability to repay financial obligations when they are due. Three liquidity ratios are prevalent among stakeholders, as mentioned above. However, they make also use the accounts receivable to sales ratio.
What is the Accounts Receivable to Sales Ratio?
The accounts receivable to sales ratio is a liquidity ratio used to measure the portion of a company’s credit sales. This ratio gauges how much sales occur on credit. Stakeholders can calculate the accounts receivable to sales ratio by dividing the accounts receivable by sales. Both of these figures are available in a company’s financial statement.
The account receivable to sales ratio provides analytics into the credit sales made by the company. These sales are crucial in helping companies grow. However, credit sales also cause issues, for example, bad debts, delayed payments, etc. For stakeholders, measuring the percentage of these sales from a company’s total revenues is highly crucial.
When companies have a higher percentage of credit sales, they may run into liquidity problems. As mentioned, more credit sales lead to long delays between the transaction and cash flows. This delay can impact a company’s ability to repay debts when they are due. Therefore, the accounts receivable to sales ratio can provide valuable insights into its liquidity position.
The accounts receivable to sales ratio looks at a company’s inclination to conduct business on a credit basis. For companies that provide these sales, this ratio can be highly crucial. Usually, the higher this ratio is, the more problems the company will have with its accounts receivable. However, stakeholders must not consider this ratio on its own but, instead, use it comparatively.
Overall, the accounts receivable to sales ratio calculates the percentage of credit sales from the total revenues. This ratio considers two elements, accounts receivable balances and total sales. The former metric comes from a company’s balance sheet. Similarly, the latter exists in the income statement. Once stakeholders obtain these figures, calculating the accounts receivable to sales ratio becomes straightforward.
How to calculate the Accounts Receivable to Sales Ratio?
The accounts receivable to sales ratio measure the percentage of credit sales of the total revenues. Companies know their credit sales portion internally. However, stakeholders cannot access that information. This ratio considers the contrast between a company’s accounts receivables and sales. Stakeholders can use the following formula to calculate the accounts receivable to sales ratio.
Accounts Receivable to Sales Ratio = Accounts Receivable / Sales
In the above equation, account receivable depicts the amount owed by customers. Since these balances exist due to credit sales, it shows the total unpaid amount from customers. However, it also represents the uncollected cash proceeds from credit sales. As mentioned, accounts receivable is a part of the balance sheet under current assets.
On the other hand, sales represent the total income generated through selling products and services. However, it does not include credit sales only. Some companies may also make cash sales. Therefore, it is crucial to separate both of them. As mentioned, the sales figure is a part of the income statement, termed as net sales or revenues.
How to interpret the Accounts Receivable to Sales Ratio?
The accounts receivable to sales ratio represents the portion of credit sales within a company’s total revenues. As mentioned, companies usually know the percentage. However, stakeholders may wish to calculate it themselves. Although this ratio does not give an accurate estimate, it still provides insights into how much credit sales a company makes.
Usually, stakeholders prefer the accounts receivable to sales ratio to below. A lower percentage implies that the underlying company is efficient in collecting its debts from customers. Therefore, it sends a positive signal of the company’s cash collection cycle. A lower accounts receivable to sales ratio also implies a lower liquidity risk. However, it is crucial to use the ratio comparatively.
The accounts receivable to sales ratio shows a company is generating large cash flows from its operations. Therefore, it does not rely on investing or financing activities to make money. However, it may also imply the company does not have enough cash sales and is, therefore, missing opportunities. In most circumstances, the former interpretation is more accurate.
A higher accounts receivable to sales ratio means a company makes a significant amount of credit sales. However, it also implies it cannot recover its debts promptly. Therefore, the ratio suggests the company may face issues with cash flows in the future. On the other hand, a higher number can also mean the company utilizes its credit facilities to generate more sales.
Example
A company, ABC Co., made total sales of $1 million. These sales include both cash and credit sales. On the other hand, the company’s accounts receivable on the balance sheet at the end of the year was $250,000. Therefore, ABC Co.’s accounts receivable to sales ratio will be as below.
Accounts Receivable to Sales Ratio = Accounts Receivable / Sales
Accounts Receivable to Sales Ratio = $250,000 / $1,000,000
Accounts Receivable to Sales Ratio = 0.25 or 25%
ABC Co.’s accounts receivable to sales ratio is 25%. However, this figure does not provide meaningful information. While stakeholders may view this ratio as high at 25%, it is crucial to look at it comparatively. They can either compare this ratio with the company’s previous financial records or with the industrial average. This way, they can get better insights into whether ABC Co.’s ratio is high.
Conclusion
Liquidity ratios allow stakeholders to measure a company’s efficiency in repaying debts when they arise. The accounts receivable to sales ratio gauges the credit sales as a percentage of total sales. Usually, stakeholders prefer this ratio to be low. It implies the company is efficient in recovering debts and generating cash flows. However, it is crucial to look at this ratio comparatively.
