The accounts receivable turnover ratio is one of the most important accounting measures.
This is primarily a yardstick to measure a firm’s effectiveness.
This is primarily with respect to effectiveness in managing the finances.
Needless to mention that this includes extending credit as well as taking debt on that.
So, in other words, you can say that this measures a firm’s resourcefulness in managing assets.
It keeps track of all debt and credit-related activity.
Better utilization of assets invariably results in better output and long standing results.
Of course, this is not a constant number.
It is directly related to the time period too.
Whenever you calculate this ratio, it relates to a particular time period.
The value, therefore, keeps changing and the efficiency of the firm too by that extension.
Therefore, this ratio factors in the most crucial time efficiency factor in any transaction.
So, in essence, it calculates the efficiency of the firm in collecting credits.
If time is money, in the literal sense, this is the most authentic measure of the same.
The longer a firm takes to collect credit sales, the more money it loses.
So if a firm maintains accounts receivable, it is in a way offering interest-free loans.
This is because the accounts receivable is essentially debt without interest.
The Best Way to Interpret Accounts Receivable Turnover Ratio
The primary question at this juncture is how will you interpret this ratio.
What I mean is well, we do understand it is a measure of financial efficiency.
But why do you really need to understand and factor in this data?
Well, the reality is it puts into perspective the operational efficiency and implications thereon.
For example, what exactly does a high receivables turnover ratio imply?
Well, you can interpret this data in a variety of ways.
It suggests that the company’s predominant operation is cash based.
Also, it goes on to signal that the company is efficient in collecting accounts receivables.
It also means that the quality of customers is quite good.
They do not keep too much of outstanding debt.
More or less, the customers maintain a strong record of balance sheet consolidation.
They invariably pay off the debt a lot faster.
As a result, it can also indicate a conservative business model by the company.
So you may consider this as a positive development.
It essentially filters out customers with questionable payment history.
But then again, it can also indicate a conservative business policy.
So, this can also result in driving away many customers.
It may also give competitors an opportunity to capitalize on and further business.
This may work against the company’s interest as well.
The receivable turnover ratio can reduce as a result too.
People sometimes prefer doing business with companies that have less stringent measures.
Similarly, the interpretation of a low accounts turnover ratio can be varied.
It can indicate sub-par credit policy or bad choice of customers.
Also, it can signal companies about a need to reassess their credit policies.
It highlights the need for timely collection and qualitative improvement of products.
How to Calculate Accounts Receivables Turnover Ratio
Now the fundamental question is how do you calculate accounts receivable turnover ratio?
Well, of course, there is a pre-decided formula for it.
It highlights the key business fundamentals and the relative cash-debt ratio.
The simple solution is dividing the net credit sales by accounts receivable over a period.
The average accounts receivable is achieved by dividing the sum of all the accounts receivable through the time period by 2.
The 2 is essentially because you are adding the accounts receivable in two.
One part adds all the accounts receivable at the beginning of the time period.
The second part adds all the accounts receivable towards the end of the time period you are considering.
So Accounts receivable turnover = Net credit sales/average accounts receivable.
You can calculate the average accounts receivable on an annual basis.
But for convenience, you can also add up these figures on a monthly or quarterly basis.
Example of Accounts Receivables Turnover Ratio
Let me explain to you with an example for better understanding.
Let’s assume we are calculating the accounts receivable turnover ratio for my company X.
My net credit sales were $500,000.
The average accounts receivable is calculated on annual basis.
So at the beginning of the year, the total accounts receivable was $50,000.
By the time, the financial year ended, the receivable turnover ratio was $62,000.
Therefore, the average accounts receivable was $50000+$62000= $112000/2=$56000
So the ratio will be $500,000 / $56000 = 8.92.
This essentially means I collect these credit receivables 8.92 times on an average every year.
You can even calculate the average duration of these accounts receivables.
On an average, dividing 365 by 8.92 yields 40.91.
So, it means my customers take an average 40 days to repay debt.
So depending on my company’s business policy, this can be a negative or positive development.
If I have a 30-day payment policy, these are instances of late payment.
On the contrary, if I have a 60-day or 90-day policy, I am getting these within the deadline.
The nature of the business also plays a key role in it.
Some businesses typically have long credit periods while there are others with shorter ones.
Depending on the nature of the business, you can decide on what is a high receivables turnover.
So the appropriate interpretation of this data is as important as the computation.
You have to take the entire business into perspective and then decide.
Also, the customer profile is important.
Sometimes you may have some long-standing clients who you may give longer credit period.
This may not mean that your credit collection period is inefficient.
You may simply be offering a specific client some advantage.
Factors to Consider While Calculating Receivables Turnover Ratio
While this is a straightforward formula, you must consider some basic facts.
The accounts receivables turnover ratio is dependent on some key elements.
It is these factors that often bring about long-term and sustainable changes.
Time is a very important factor in comparing this data.
It can provide very insight only when you compare a time period against another.
For example, let’s say you are comparing the performance in Q3 Vs Q4.
Or for that matter, you can compare the performance in a specific financial year Vs another.
The trend is up and down with regards to a specific time period.
The time period is what ascertains the type of action that needs to be incorporated.
The period, however, is arbitrary.
The time that you choose is the beginning of the transaction and one that as the end is your wish.
There is no specific rule about what defines as the beginning period.
So I may take a 6-month period while another company in the same industry may take the annual assessment.
But even a month’s difference can make a huge difference in the computation.
The balance can reflect a significant difference.
So depending on your end use, you may choose similar dates or different ones.
However, if you need specifics, remember that the accounts receivable ratio is an average.
Though it is considering specific accounts receivable turnover data, the final number is not.
It is an average assumption of a firm’s credit efficiency.
It is only an indicator of the broad trend.
This is never a pointed analysis of specific developments.
Most importantly, the qualitative analysis of the data will differ.
It depends on many aspects like the industry and quality of service.
So, different sectors may generate differing analysis.
How to Use Receivables Turnover Ratio?
One of biggest use of accounts receivable turnover ratio is assessing a company’s health.
More specifically, it offers the most pointed assessment of a company’s financials.
It offers a much deeper insight into the overall operations of a company.
For example, it can also reveal the long-term trend.
Let’s assume a company you liaison with is facing some credit issues.
But this can be a temporary aberration as well.
The only way, you will get to know this is by going through the company’s receivables turnover ratio.
If you see this indicating a particular trend or if a specific pattern is repeated, you can take a call.
You can also get a more realistic picture of the company’s credit practices.
Whether it is a large establishment or small, the long-term trend can provide specific direction.
It will help you analyze the business worthiness of the firm over an extended period.
Moreover, you can use this data to compare two firms.
Let’s say you have two companies from the same industry offering interesting deals.
The question is how you can choose between the two.
The common understanding will tell you that you must choose the better monetary offer.
But that may not be relevant at all times.
The business fundamentals of a company are equally important.
One simple option is referring to the accounts receivable turnover ratio of multiple firms.
So if a company has a higher ratio compared to the other, the choice is quite simple.
But if as a customer, you are not comfortable with the short credit period, you can take a call.
You may choose the company with a lower accounts receivable turnover ratio.
If that aligns with your credit policy, it will help further your business better.
Helping You Opt for Safer Investments
As an investor too, this data is extremely crucial.
It enables you to differentiate between safe and risky businesses.
The credit cycle is undeniably one of the best reflection of the cash situation.
Supposing I am interested in investing in Company X.
My due diligence will include going through the balance sheet and studying long-term trend.
The accounts receivable turnover ratio is one of the best ways to assess this trend.
In a matter of seconds, you can easily take a call on a potential investment target.
So, in a way, this ratio helps you make an informed call.
In many ways, the earnings projection or numbers can be manipulated.
But the accounts receivables are hard facts.
This particular data is corroborated both by the sender and the receiver.
So they also reflect a certain degree of transparency about them.
It will highlight the actual credit situation and the risk involved.
So you can easily avoid businesses with high bad debt or loose credit records.
If the turnover indicates a worsening pattern, it will help you analyze the why and how of it.
You can easily decide if there are other underlying problems with the firm.
The low accounts receivable turnover ratio does not necessarily indicate poor credit collection.
Perhaps the problem is in other associated departments like distribution or customer service.
So in many ways, it highlights a comprehensive operational matrix.
Problems of Receivables Turnover Ratio
But you have to understand that there are some problem areas too.
You have to consider these limitations in proper perspective to draw a realistic picture.
The use of net sales is often under much discussion.
The accounts receivable turnover ratio specifies net sales.
However, there are many companies which use total sales instead.
Now you must understand, in pure balance sheet terms, the two are very different.
As a result, the ratio that each one yields is also very different.
Total sales will generally inflate the accounts receivable turnover ratio.
So if you don’t consider specific details, you may be taken for a ride.
Now I do not mean that companies want to mislead deliberately.
But you must consider the details of how a company computes this data.
Only then, you can be very sure about the exact picture this ratio depicts.
Accepting it at mere face value may yield conflicting results.
It may completely change the financial projections of a company.
So if you are that keen, you may want to calculate this ratio separately.
The time period also continues to be a key area of concern.
Sales can vary differently over the course of the year.
There are some periods where you may have large chunks of the collection.
There may be some lean periods too.
Now if you pick the start and end to depict a specific picture, it will never be a true reflection.
It will hardly portray the true state of affairs.
On the contrary, it may misguide investors about the trend and development in a certain sector.
Any assumption based on these calculations will be flawed.
You have to then take into consideration, the independent monthly data.
You may have to calculate the average of accounts receivable every month.
Comparisons Have to Be Industry Specific
Another important factor in this regard is the relative comparison.
You must remember that the comparisons should be made only in same industry.
Different industries and sectors have very different credit cycles.
The sales peaks and crests also differ industry wise.
For example, typically automotive sales are much higher during the festive season.
However, the same is not true about pharma companies.
So for a specific time period, you cannot compare the two on same parameters.
Ideally, you must also compare companies with similar business models.
This is because companies operating at different scales will have varying capital construct.
The financial structure of large companies is very different from smaller ones.
So when you compare them on a similar yardstick, the result will be flawed.
In this case, the accounts receivables turnover ratio will not be useful for comparison.
It will fail to highlight any long-standing point of concern or quality.
Moreover, the circumstances under which you are considering this data is crucial.
These may not be an ideal indicator of a company’s credit health in many cases.
You have to always look at these numbers in a holistic fashion.
Only when they account for the other uncertainties, you can deduce an appropriate conclusion.
Accounts Receivable Turnover Ratio Is a Crucial Data
But you have to use it in the right perspective.
You have to be aware of the limitations of computing this ratio.
Additionally, you must have a full grasp of the sales cycle and credit condition.
Moreover, this ratio can be easily impacted by sector-specific developments.
Only when you consider all these facts, you can hope to get a realistic picture.
At best, it is a measure of a company’s individual financial mettle.
A broad group comparison requires considering other factors too.
So when you analyze a specific unit, you can use accounts receivable turnover ratio.