What is the receivable turnover ratio?
We are going to learn one of the components of the ratio analysis that is the accounts receivable turnover ratio which every entrepreneur is always concerned about how the turnover of account receivable is happening.
We can define the receivable turnover ratio as it is a part of ratio analysis and kind of asset management ratio. It is used to measure how effective the way a company collects its receivables or debts from its business partner or clients.
I mean what is a timeframe so that’s what they are always looking for? Let’s understand how fast a company can manage to collect its debt from the customers or pay the same to others.
This ratio is related to the company’s account, which is why known as account receivable turnover ratio.
In simple words, it determines how many times a company collects its receivable during the current fiscal year.
The time frame for collecting the receivable depends on the production cycle and financial health of the company.
Generally, this time frame for some companies is 90 days while some companies take 6 months to collect receivables from the customers.
Advantage of Receivable Turnover Ratio
- It checks the effectiveness of the collection of receivable from the clients.
- A high value of this ratio indicates the collection account receivable is efficient and the party pays the due quickly.
- It monitors and tracks the current trend of the market for collection.
- This shows the efficiency of the management of a company.
- It also determines how efficiently using its assets to collect the due.
- Good staffing and scheduling give effective results in the collection.
- More in the collection, more liquidity, and cash to the company.
The disadvantage of Receivable Turnover Ratio
- It can vary every moment in a fiscal year.
- This ratio is not able to show the effectiveness of issuing and collecting due.
- Sometimes uses the total sales instead of net sales.
- In the case of poor management for the collection of the receivable, the company turns into a financial burden.
- Loose bonding in collection generates resistance in the growth of the company.
- A low value of this ratio indicates poor management in the collection of due.
The formula of Receivable Turnover Ratio
Let’s understand the Formula the receivables turnover ratio formula is something like this the net credit sales. Absolutely, you are analyzing that right divided by the average accounts receivable so from the net credit sales.
Let’s understand what exactly we are talking about here. Now account receivable turnover is basically another name of the turnover ratio.
Now in this ratio, we will consider the credit sales and the accounts receivable.
What are the net credit sales?
The amount that the firm would receive due in the near future and sales made o the basis of credit is called credit sales.
The sum of the total number of credit sales is called total credit sales.
Here, lets when you minus the credit as returns and allowances from total credit sales, would be net credit sales.
These figures can find from the income statement of the balance sheet of the company for a particular financial year.
What is the average account receivable?
When a firm sells its goods on a credit basis it takes a decent time to get the collection.
So the amount that the firm would receive due to the credit sales in the near future is called accounts receivable.
For averaging the account receivable, let’s take the total number of accounts receivable at the beginning of the year plus the total number of accounts receivable at the end of the year. The resultant is divided by 2.
These figures are available in the balance sheet of a company. You can extract the figure from there.
Extraction of formula
Now, this ratio is a measure that computes the proportion of how much the net credit sales a firm has and how much average account receivable form is dealing with.
Now let’s have a look at the formula the receivables turnover ratio. RTO is equal to your net credit sales divided by your average accounts receivable right.
So let’s understand with the help of an example so that you may have a clear idea of what we are trying to compute.
Example of Receivable Turnover Ratio
Let’s say, there’s a company called ABC Inc and they have the following data like net credit sales data. Let’s say in dollars. They have some accounts receivable data as $40,000 and they have this is basically the opening data and we have an account receivable closing data is $60,000. The total credit sales of $5,10,000 and credit sales returns of $10,000.
Now find out the account receivable formula over here. Now in this above example, we’ll have all the information available. First, we will find out the average account receivable.
So the average account receivable is going to be your opening. So I’ll put this in a bracket. We’ll have the opening plus the closing and then we’ll divide by two which will give us $50,000.
Let’s get net credit sales, minus the credit sales return $10,000 from total credit sales $5,10,000, we will get $5,00,000
So by using the formula of account receivable turnover, we’ll get something like, this AR turnover ratio is equal to your net credit sales divided by the average account receivables.
So let’s try and put the numbers net credit sales is your file AK divided by 50,000 which will give us 10 times.
If we compare the ratio with other companies under a similar industry we’ll be able to interpret whether this number is efficient or not?
Receivable Turnover Ratio in Days
The above example is calculated for a fiscal year. Now let’s need to know the result in days, so calculate the above result.
The RTR (Receivable Turnover Ratio) in days represents the average number of days of time span in which a party may pay the credit sales to the company.
Following is the formula of account receivable turnover ratio:
Therefore, to collect credit sales takes time in days approximately 37 days. So the company should set a timeline for the credit facilities to the customers on the basis of 30 days policy. The value of the ratio in days shows some late payment to the company.
Interpretation and Analysis of Receivable Turnover Ratio<>
The higher receivable turnover ratio implies that the higher frequency of converting the receivables into cash which is of the curtain.
It’s absolutely a good thing because if you are able to convert your receivables into cash quickly that means you have high liquidity. And that’s good for the company. That’s good for the pocket of the company right.
This ratio is related to activity and efficiency that is why it is called efficiency ratio. This is an indicator of the operational and financial performance of the company.
A high value of this ratio also shows the high-quality base customers who are able to pay the credit sales quickly.
Do you know the credit policy for the collection of credit sales?
Let’s know the credit policy; it is a policy for the company which provides the credit sales to the customers.
The company should set itself credit policy as per the operational cycle that can make available the fund to the company for next and continuity of operation.
Generally, the credit policy is for the company in the range of 30 days, 20 days, and 10 days to get a high value of this ratio.
It depends on the culture and sector of the concerned company.
So now let’s get back to our explanation on the account receivable turnover formula. Now in the above ratio, we have two components the first component is the net credit sales.
We need to keep in mind that here we cannot take the total net credit sales. We need to separate the cash sales and the credit sales and that we need to deduct any sales return.
Remember this thing very sure that you know you did need to deduct any sales unrelated to the credit sales from the credit scene.
So you could so your sales are going to be your credit sales minus any sales return then you will get the right answer.
The second component is the average this is your first component okay. Your average accounts receivable average accounts receivable.
So to find out the average account visible we need to consider two elements again the opening account receivable and the closing to find out the average of the two.
Now, what is exactly the significance the use of the account receivable formulas see account receivable turnover is basically an efficiency ratio?
It is used to see how many times the account receivable has been seen collected during the fiscal year.
You’re right now the third thing had the higher the account receivable turnover ratio is healthy as we have already discussed okay.
That’s healthy for the company and it denotes that the time interval between the credit sales and the receipt of the cash is low.
That means that the form is quite efficient in collecting the account receivable. On the other hand, a low lower accounts receivable turnover ratio is not good or enough for the company.
And against at the time interval between the credit sales and the receipt of the money is higher.
As a result, there is always a risk of not receiving the money that’s called the bad debts right.
When an investor looks at the account receivable turnover he or she needs to know how efficient the form is in connecting the two amounts. If there is a risk in dealing or noticing the payment it may directly affect the cash from the company.
Now, this is your account receivable turnover calculator if you put numbers over here. Let’s say your net credit sales are 1 million okay and your average accounts receivable which are standing in your balance sheet is filed.
So it’s going to be half so you mean you are saying that you know my net credit scenes are 1 million but the amount outstanding that I have to recover from the daters is only five lakh dollars.
So what’s going to be a receivable turnover ratio two times right. So that’s a good that’s a bad number. You can say no. You are only able to convert your net-great sales only two times into cash.
Now as this number is going to increase. Let’s say we are going to make it six like your data will go down which means your receivable turnover ratio will go down.
So what interpretation we can make as the account receivable goes down keeping the net credit sales.
As the same, your receivable turnover goes down and that means it’s not good but as this amount decreases. It will automatically increase and if we put one lakh tall.
Over here we’ll get 10x as the number so put down your own numbers and try and make an interpretation of the same.
Thank you, everyone