Study: Compute and Understand the Accounts Receivable Turnover Ratio
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1. Read Accounts Receivable Turnover
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Slides 1-3 (1m:06s)
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Welcome to Introduction to Accounting Preparing for a User's Perspective
Compute and Understand the Accounts Receivable Turnover Ratio
What can the accounts receivable turnover ratio tell you?
The accounts receivable turnover ratio (AR turnover ratio) indicates how effective and efficient management is at granting credit to and collecting cash from credit customers. When management takes too long to collect cash from customers it will often have difficulty paying its own suppliers.
In general, well-run credit and collection departments are usually able to collect their receivables within 30 days of the date of sale. In fact, many businesses specify "net 30 " days on their invoices to ensure that customers know they expect full payment within 30 days of the date of sale. A 30 day collection period (i.e. one month) equates to an AR turnover ratio of 12 times per year, meaning, the company is able to sell and collect an amount equal to its average accounts receivable balance 12 times per year.
Slides 4-5 (1m:26s)
Links to an external site.The larger the AR turnover ratio, the more often they sell and collect during the year and the shorter the days in receivables will be, which is also known as the collection period and the days to collect. The smaller the AR turnover ratio, the less often they sell and collect their AR during the year and the longer they will take to collect on their receivables.
For example, assume that ABC Co. and DEF Co. have AR turnover ratios of 10 and 20, respectively. Which company do you think is able to collect on its receivables the quickest? Because there are 365 days in a typical year, all you have to do is divide 365 by the AR turnover ratio, which is the number of times each company turns its average receivables balance over into cash, to arrive at the days it takes to collect as follows:
- ABC Co. takes 36.5 days to collect (i.e. 365 days per year / 10 AR turnover ratio);
- DEF Co. takes 18.3 days to collect (i.e. 365 days per year / 20 AR turnover ratio)
ABC takes 36.5 days to collect, which is twice as long as DEF's 18.3 days. DEF's shorter collection period, will tend to make it more liquid and thus more able to pay off its current liabilities when they come due.
Slide 6 (0m:26s)
Links to an external site.In general a low AR turnover ratio and a long AR collection period is a sign of poor credit and collection management possibly indicating:
- management takes too long to bill its customers,
- management does not catch billing errors,
- management is overly lenient and grants credit to persons who are unable to pay,
- management records fictitious/fraudulent credit sales,
- etc.
Slides 7-8 (0m:55s)
Links to an external site.In general a high AR turnover ratio and a short collection period is a sign of good credit and collection management; however, a collection period that is too short can actually be a sign of poor credit and collection management that can significantly reduce sales such as:
- management only allows cash sales
- management only grants credit to AAA rated customers, thus preventing credit sales to customers who really would pay if given time to pay,
- management is overly aggressive in its collection efforts (i.e. harassing phone calls, rude letters, and big ugly mean men)
- customers may pay up quickly when threatened, but will likely never buy from the company again and will discourage their friends from buying there as well
It should be clear that credit and collection management is a balancing act between ensuring full and timely payment and increasing credit sales and the company's customer base.
Slides 9-11 (1m:31s)
Links to an external site.How do you compute the accounts receivable turnover ratio?
The accounts receivable turnover ratio is computed as follows:
Net Credit Sales: Net Credit Sales represent all sales made on account (i.e. credit sales) less any returns and allowance on credit sales and less any sales discounts on credit sales. Having said that, many users will use the "Net Sales" figure directly off the Income Statement to compute the AR turnover ratio because the Net Credit Sales figure is not readily available. One drawback to using Net Sales is that although it does include the net of all sales on account, it also includes the net of all cash sales which can inflate the AR turnover ratio. Just make sure that when you compare the AR turnover ratio of different companies that you ensure that you use the same numerator, whether it be net credit sales or net sales.
Average Accounts Receivable: Average accounts receivable represents the average of the beginning AR and the ending AR. It is computed by adding beginning accounts receivable to ending accounts receivable and dividing the sum by 2 to arrive at the average for the period. The average is used to eliminate some of the fluctuation in the account from the beginning of the period to the end.
Slide 12 (0m:50s)
Links to an external site.Example Computation: Company A's prior year ending balance sheet showed accounts receivable of $100, which will become the beginning balance for the current year. The current year balance sheet showed ending accounts receivable of $60. By adding the two balances we get $160 which we then divide by 2 to get the average Accounts Receivable for the year of $80. During the year, it generated $1,200 of Net Credit Sales resulting in an AR turnover ratio for the year of 15 as is shown here:
This means that Company A was able to make credit sales of $80 and then turn them over into cash 15 times during the year. That is a pretty good AR turnover ratio, but it becomes more interesting when we compute the number of days Company A takes to collect $80 of credit sales.
Slide 13 (0m:38s)
Links to an external site.If we were to take the 365 days of a normal year and chop it up into 15 equal collection periods representing the company's AR turnover ratio of 15, we would get 15 collection periods during the year of 24.3 days each computed as follows:
If the industry average collection period were 27 days, it would seem that Company A is managing its credit and collection process comparatively more effectively and more efficiently than the industry.
Slide 14 (1m:24s)
Links to an external site.Let's now tie the AR turnover ratio and the AR collection period together to show that if you already know 3 of the four variables, you can solve for the missing one.
Example: Let's assume that you know a company has an AR collection period of 20 days and you know it has Net Credit Sales of $100 M, you can use the following diagram to solve for the company's Average Accounts Receivable balance.
Slide 15 (0m:52s)
Links to an external site.How do you use the accounts receivable turnover ratio?
Although it is interesting to know that a company has an AR turnover ratio of 15.9, and has a corresponding AR collection period of 23 days, these ratios become even more interesting when compared to the same company's ratios for the prior several years to determine whether management is getting better or worse at managing its credit and collections departments.
Please review the AR turnover ratios and the AR collection periods for the years noted below to determine whether management's credit granting and collecting effectiveness and efficiency are improving or worsening.
Due to the fact that the company's AR turnover ratio is increasing and its AR collection period is decreasing, it would appear that management is improving its credit granting and collection processes.
Slides 16-18 (0m:55s)
Links to an external site.In addition, as noted previously, wise users will also compare a company's AR turnover ratio and collection period to the industry average as a means of benchmarking its performance. If a given company has an AR turnover ratio of 8.1 and is therefore taking 45.1 days to collect and the industry has an average AR turnover ratio of 15 thus taking about 24.3 days to collect, management might want to review its credit granting and collecting processes and procedures to see what can be done to improve their efficiency and effectiveness.
In summary, you should be able to define and compute the AR turnover ratio and AR collection period. Be able to use a company's AR turnover and AR collection periods to assess management's credit granting and collecting as compared to its past and to its industry.
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