02 Mar Accounts Receivable Turnover Ratio
The accounts receivable turnover is designed to evaluate how well companies utilize their assets to bring in more income. In plain English, it is designed to calculate how many times the company can collect its average accounts receivable during the period of the year.
When a company collects its average receivables in the year, it is called a turn. With this in mind, if the company collects double the account receivables in one year, then it has turned its account receivable two times. This equation is composed to show the productivity of the company in regards to collecting the outstanding credits from its clients.
The account receivable collection period can vary from one company to another; however, the average account receivable collection period is determined by calculating the turnover ratio.
Before knowing exactly how many times a company collects receivables, you will have to calculate the turnover ratio first. To calculate the accounts receivable turnover ratio, you will need two numbers: the net credit sales, and the average accounts receivable.
Account Receivable Turnover Ratio Equation
The account receivable turnover ratio is calculated by dividing the Net Credit Sales by the Average Accounts Receivable.
The net credit sales is the gross sales on the company’s credit, minus the sales returns, allowances, and any sales discounts that relates to the sales on the credit.
Net Credit Sales = Sales on Credit – Sales Returns – Sales Allowances
The Average Accounts Receivable can be calculated by adding the first account receivable in the year and the ending receivable, and then dividing them by two.
Average Accounts Receivable = beginning receivable + ending receivable / 2
Turnover Ratio = Net Credit Sales / Average Accounts Receivable
To further breakdown the account receivable turnover ratio, the company measures its consistency in collecting its accounts receivable by calculating the turnover ratio, which means the higher the ratio is, the more the collection is. If a company has a turnover ratio of four, it means it collects its account receivables four times per year, which is every three months. Another company could have a turnover ratio of three, which means it collects its accounts receivable once every four months. The more the company collects, the more it’s getting paid back from its clients.
A big part of a company’s success can be measured by how frequent they are collecting their credits, as these collections can be used for various business expenses to progress the company further.
To paint the picture even further, here is an illustration of a real life situation:
A small business owner that sells automotive parts compared his balance sheets’ accounts receivable from the prior year with the current year. The previous year, the business’ balance sheet showed $6,000. The balance sheet for the current year showed $12,000. The business gave gross credit sales of $60,000, but only received $30,000 in credit returns.
To calculate the turnover ratio for this small automotive parts business, we need to calculate the net credit sales and the average accounts receivable.
To calculate the Net Credit Sales, we need to subtract the credit returns from the gross credit sales.
Net Credit Sales:
$60,000 – $30,000 = $30,000
To calculate the Average Accounts Receivable, we need to average the accounts receivable from both the prior year and the current year.
Average Accounts Receivable:
($6,000 + $12,000) / 2 = $9,000
Lastly, to calculate the Accounts Receivable Turnover Ratio, we have to divide the Net Credit Sales by the Average Accounts Receivable.
Accounts Receivable Turnover Ratio:
$30,000 / $9,000 = 3.33
This little turnover ratio number can say a lot about this small automotive parts business. The 3.33 means for each time this business gives credit to customers, it can collect it 110 days later. Which also means it collects its receivables approximately three times each year.