Accounts Receivable Turnover Ratio Meaning Formula

Accounts Receivable Turnover Ratio Meaning

A higher accounts receivable turnover ratio is desirable since it indicates a shorter delay between credit sales and cash received. On the other hand, a lower turnover is detrimental to a business because it shows a longer time interval between credit sales and cash receipts. Additionally, there is always the possibility of not recovering the payment.

Providing a line of credit Line Of CreditA line of credit is an agreement between a customer and a bank, allowing the customer a ceiling limit of borrowing. The borrower can access any amount within the credit limit and pays interest; this provides flexibility to run a business.read more is one thing, but collecting this ‘interest-free loan’ from the debtors is another.

Accounts Receivable Turnover Formula

The accounts receivable turnover is calculated by dividing the net credit sales by the average accounts receivableAccounts ReceivableAccounts receivables is the money owed to a business by clients for which the business has given services or delivered a product but has not yet collected payment. They are categorized as current assets on the balance sheet as the payments expected within a year. read more. Net credit sales are considered instead of net sales because net sales include cash sales, but cash sales do not fall under credit sales.

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Accounts Receivable Turnover Ratio Formula = (Net Credit Sales) / (Average Accounts Receivable)

In the above ratio, we have two components.

Net Credit Sales = Gross Credit Sales – Returns (or Refunds). We must remember that we cannot take the total net sales here. We need to separate the cash sales and credit sales. And then, we need to deduct any sales return from the credit sales.Average accounts receivables – To find out the average accounts receivable (net), we need to consider two elements – accounts receivable (opening) and accounts receivable (closing) and find the average of the two.

Calculation Examples

In 2010, a company had a gross credit sale of $1000,000 and $200,000 worth of returns. On 1st January 2010, the accounts receivable was $300,000, and on 31st December 2010 was $500,000.

Based on the above information:

Average accounts receivable = (3,00,000 + 5,00,000) / 2 = ₹4,00,000Net credit sales = 10,00,000 – 2,00,000 = 8,00,000Receivable turnover = 8,00,000 / 4,00,000 = 2.

From the above example, the turnover ratio is 2, which means that the company can collect its receivables twice in the given year or once in 182 days (365/2).

In other words, when making a credit sale, it will take the company 182 days to collect the cash from the sale.

Interpretation

A higher ratio means the company collects cash more frequently and/or has a good quality debtor. In turn, it means the company has a better cash position, indicating that it can pay off its bills and other obligations sooner. In addition, the accounts receivable turnover often is posted as collateral for loans, making a good turnover ratio essential.At the same time, a high turnover ratio may also mean that the company transacts mainly in cash or has a strict credit policy.A lower ratio may mean that either the company is less efficient in collecting the creditor, has a lenient credit policy, or has a poor-quality debtor.The number (turnover ratio) does not give the complete picture. It is better to check for the turnover ratio trends over the years to assess the true collecting efficiency of the companies. In addition, many prudent analysts analyze if the company’s ratio affects its earnings. Comparing the turnover ratiosCompare The Turnover RatiosTurnover Ratios are the efficiency ratios that measure how a business optimally utilizes its assets to generate sales from them. You can determine its formula as per the Turnover type, i.e., Inventory Turnover, Receivables Turnover, Capital Employed Turnover, Working Capital Turnover, Asset Turnover, & Accounts Payable Turnover. read more of two companies in the same industry is also useful.

Accounts Receivables Turnover of Colgate

Now that we have seen how to calculate the asset turnover ratio,Asset Turnover RatioThe asset turnover ratio is the ratio of a company’s net sales to total average assets, and it helps determine whether the company generates enough revenue to justify holding a large amount of assets under the company’s balance sheet.read more let us know the turnover ratio for Colgate.We have assumed that all Colgate’s income statement sales are credit sales.The following image shows the average receivables turnover for 2014 and 2015: –
Colgate’s accounts receivables turnover has been high at around 10x for 5-6 years.Higher turnover implies a higher frequency of converting receivables into cash.

How is Colgate’s accounts receivables turnover ratio compared to P&G and Unilever?

We note that the P&G receivable turnover ratio of around 13.56x is higher than that of Colgate (~10x).Unilever’s receivables turnover is closer to that of Colgate.

Precautions

As investors, they should take care to calculate the turnover ratio. Many firms consider gross credit sales rather than net credit sales Net Credit SalesNet credit sales is the revenue generated from goods or services sold on credit excluding the sales discount, sales allowance and sales return. It even amounts to the accounts receivables for a certain accounting period.read more. It can be misleading if not paid attention to.

Also, as stated above, the average receivable turnover is calculated by considering only the first and last months. Therefore, it may not give the correct picture if the accounts receivables turnover has drastically varied over the year. To overcome this shortcoming, one can take the average over the whole year, i.e., 12 months instead of 2.

Accounts Receivable Turnover Ratio Meaning Formula