- Calculate accounts receivable turnover and number of days sales in receivables
Accounts receivable turnover is the number of times per year a business collects its average accounts receivable. The ratio is used to evaluate the ability of a company to efficiently issue credit to its customers and collect funds from them in a timely manner.
To calculate receivables turnover, add together beginning and ending accounts receivable to arrive at the average accounts receivable for the measurement period, and divide into the net credit sales for the year. The formula is as follows:
[latex]\dfrac{\text{Net Annual Credit Sales}}{\frac{\text{Beginning Accounts Receivable} + \text{Ending Accounts Receivable}}{2}}[/latex]
For example: [latex]\dfrac{994,000}{\frac{108,000 + 91,000}{2}}=10.0[/latex]
| Description | 2019 | 2018 |
|---|---|---|
| Sales | $994,000 | $828,000 |
| Cost of merchandise sold | 414,000 | 393,000 |
| Gross Profit | Single Line$580,000 | Single Line$435,000 |
| 2019 | |
|---|---|
| Assets | |
| Subcategory, Current assets: | |
| Cash | $373,000 |
| Marketable securities | 248,000 |
| Accounts receivable | 108,000 |
| Merchandise Inventory | 55,000 |
| Prepaid insurance | 127,000 |
| Total current assets | Single Line$911,000 |
The more often customers pay off their invoices, the more cash is available to the firm to pay bills and debts, and less possibility that customers will never pay at all.
A high turnover ratio could indicate a credit policy, an aggressive collections department, a number of high-quality customers, or a combination of those factors.
A low receivable turnover may be caused by a loose or nonexistent credit policy, an inadequate collections function, and/or a large proportion of customers having financial difficulties. A low turnover level could also indicate an excessive amount of bad debt and therefore an opportunity to collect excessively old accounts receivable that are unnecessarily tying up working capital. It may be useful to track accounts receivable turnover on a trend line in order to see if turnover is slowing down; if so, an increase in funding for the collections staff may be required, or at least a review of why turnover is worsening.
Average Collection Period
The days’ sales in accounts receivable ratio (also known as the average collection period) tells you the number of days it took on average to collect the company’s accounts receivable during the past year.
The days’ sales in accounts receivable is calculated as follows: the number of days in the year (use 360 or 365) divided by the accounts receivable turnover ratio during a past year.
In our example, this would be [latex]\dfrac{365}{10} = 36.5[/latex] days on average to collect cash from a sale on account.
This ratio, like any other, is a high-level indicator, designed to bring attention to problem areas.
It is possible that within the average accounts receivable balances some receivables are 60, 90, or even 120 days or more past due that are skewing the average. Therefore, it is best to review an aging of accounts receivable by customer to understand the detail behind the days’ sales in accounts receivable ratio.
Now, let’s check your understanding of this topic.