December 25, 2020

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Accounts Receivable Turnover Ratio

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Accounts Receivable Turnover Ratio

The impact of accounts receivable on the company’s financial position is ambiguous. A significant amount of accounts receivable can lead to a need to attract additional funds due to the outflow of the company’s own cash. On the other hand, selling on credit to customers contributes to an increase in the level of sales due to the fact that for many customers, deferred payment is a priority when choosing a seller/supplier. If the profit from an increase in sales exceeds the cost of attracting additional borrowed funds, an increase in the turnover of accounts receivable will have a positive effect.

Receivables turnover ratio: Definition

An accounts receivable turnover ratio is an indicator of business activity that shows the effectiveness of managing the debt of clients and other debtors. The value of the ratio demonstrates the number of accounts receivable (AR) turnovers, that is, how many times the debtors have paid off their obligations to the company during the reporting period.

The indicator determines how many times accounts receivable were successfully turned into cash or how much revenue was received from 1 dollar of accounts receivable. The indicator measures the efficiency of work with customers in terms of collection of receivables, and also reflects the organization’s policy regarding sales on credit.

Formula and Example

The receivables turnover ratio is calculated as the ratio of sales proceeds to the average amount of receivables for the period.

To receive a net credit sales value, you would need to deduct any returns from the credit sales. How do you get the average amount of accounts receivable required in the formula? You are going to need to sum the beginning and ending accounts receivable and divide the result by two.

Let’s say we have $160,500 as net credit sales. The receivables were $67,000 at the beginning of the quarter and $42,000 at the end. We calculate that the average AR is $54,500. Dividing the two figures, we are going to get a ratio of roughly 2.94. In other words, we collect our AR 2.94 time in a quarter.

What does the change in the accounts receivable turnover ratio mean?

There are no clear norms for the turnover of accounts receivable since it strongly depends on the industry characteristics and the enterprise itself. If the AR turnover rate is 0, it means that the enterprise either has no debts owed by its debtors, or it does not carry out credit sale activities at all.

Accounts Receivable Turnover Ratio

An increase in AR turnover means that the company is working more smoothly. The higher its value, the shorter the period of time elapses between the shipment of products to consumers and the moment they are paid. High values of this indicator have a positive effect on business liquidity and solvency.

Usually, a problem arises when there is a decrease in the turnover of accounts receivable (debts from buyers are returned with delays) because it negatively affects the activities of the business.  If such a problem has arisen once, then it is necessary to find a way to return the company’s funds. 

If this is a recurring problem, then it is necessary to draw up a comprehensive and clear policy for providing credit sales to customers and a way to improve the turnover. For example, you should divide all clients into groups based on the history of cooperation, the importance of each of them, and the current financial condition. You would also choose whether the company will lend only to the most reliable customers or will try to maximize the level of sales and give a loan to everyone except potential bankrupts.

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Author: Charles Lutwidge

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