What a receivable turnover calculation is?

What a receivable turnover calculation is?

Start with the formulation. 

Accounts Receivable Turnover Ratio = Net Annual Credit Sales / ((Beginning Accounts Receivable + Ending Accounts Receivable) / 2)

Sales on credit - Sales returns - Sales allowances = Net credit sales

Accounts Receivable Turnover Ratio = (Sales on credit - Sales returns - Sales allowances)/Average Net Accounts Receivable

Sample of The Calculation (Case 1)

In this case, I set the average number to a lower level to reflect a healthy financial situation.

Assume I am running a construction company called Starbruce had an annual net credit sales of $1,000,000 during 2019. The beginning accounts receivable (net of uncollectible) is $60,000, and ending accounts receivable (net of uncollectible) is $40,000. The average net accounts receivable = $50,000 (($60,000 + $40,000)/2)

The turnover ratio is “20” = $1,000,000 / $50,000

Thus, Starbruce's accounts receivable turned over 10 times during the past year, which means that the average account receivable was collected approximately in 19(18.25) days.

Sample of The Calculation (Case 2)

In this case, I set the average number to a higher level to reflect an unhealthier financial situation.

Assume that Starbruce had an annual net credit sales of $1,000,000 during 2019. The beginning accounts receivable (net of uncollectible) is $950,000, and ending accounts receivable (net of uncollectible) is $850,000. The average net accounts receivable = $900,000 (($950,000 + $850,000)/2)

The turnover ratio is approximately “1”(1.111) = $1,000,000 / $900,000

Thus, Starbruce's accounts receivable turned over 1 time during the past year, which means that the average account receivable was collected approximately in 365 days.

Review the case 1 and case 2, we can see a tremendous difference between the expectation of how many days does the company take to collect its account receivable. Moreover, it also means the Starbuce has to forego the alternative use of the money, or even cut down the reinvestment on the growth of its business, and the interest income is also way different between the two. The 346(365-19) days difference can be a significant loss on interest income if you deposit huge amounts of money in a bank. 

Let's see other different cases which have the same average net accounts receivables, but a different beginning and ending amounts of accounts receivables.

Sample of The Calculation (Case 3)

In this case, I set very high and low amounts of account receivables to reflect the tricky of the average number.

Assume Starbruce had an annual net credit sales of $1,000,000 during 2019. The beginning accounts receivable (net of uncollectible) is $850,000, and ending accounts receivable (net of uncollectible) is $50,000. The average net accounts receivable = $450,000 (($850,000 + $50,000)/2)

The turnover ratio is “2”(2.2222) = $1,000,000 / $450,000

Thus, Starbruce's accounts receivable turned over 10 times during the past year, which means that the average account receivable was collected approximately in 182.5 days.

Sample of The Calculation (Case 4)

Assume that Starbruce had an annual net credit sales of $1,000,000 during 2019. The beginning accounts receivable (net of uncollectible) is $500,000, and ending accounts receivable (net of uncollectible) is $400,000. The average net accounts receivable = $450,000 (($500,000 + $400,000)/2)

The turnover ratio is “2”(2.2222) = $1,000,000 / $450,000

Thus, Starbruce's accounts receivable turned over 10 times during the past year, which means that the average account receivable was collected approximately in 182.5 days.

As you can see, the average net accounts receivables are the same. But the beginning and ending amounts are very different. It may cause by choosing a specific period, or similar to the very last day of a credit card bill. If a note receivable is in a 2-year promise, the accounting result would be very different between choosing 1 and 2 years. 

What does it mean?

Accounts Receivable Turnover Ratio reveals how many times a firm’s receivables are converted to cash during the year. A high turnover ratio may indicate a conservative credit policy or several high-quality customers. For instance, American Express qualifies its clients by charging them a higher annual fee relative to other credit card companies. 

On the other hand, a low turnover ratio represents a loose credit policy, an inadequate collections function, or a large proportion of customers having financial difficulties. 

How it is used?

The ratio is used to evaluate the ability of a company to efficiently issue credits to its customers and collect funds from them promptly. It also indicates an excessive amount of bad debt. It is used to track the collection activities, and drawing a trend line to see its efficiency. But just be careful the tricky cases like I introduced priorly.

Notice that the net credit sales are revenues generated by a firm that it allows to customers on credit. Therefore, net credit sales do not include any sales for which payment is made immediately in cash.