Understanding Accounts Receivable TurnoverAccounts Receivable Turnover allows a company to measure whether or not the company is effectively collecting payments for sales on credit. A high turnover indicates higher cash basis sales or efficient collections. A low turnover indicates collection problems and possible bad debts. Most companies do not charge interest on Accounts Receivable unless the account becomes past due. An extension of credit is then essentially an interest free loan to customers, and not collecting payments on time creates inefficiency and opportunity costs for the company. For example, the company could use the cash to invest the money and earn interest, pay down debt from which the company is incurring interest expenses, or finance growth opportunities instead of having money tied up in Accounts Receivable. So why sell products on credit in the first place? Firms expect that by selling on credit, they can achieve better sales and profits than they would if their sales were on a cash basis only. Even though a firm runs the risk of not being able to collect on some receivables, it expects that these uncollectible accounts and associated costs of credit sales will be sufficiently offset by an increase in sales and, in turn, an increase in net income.
To encourage prompt payment, companies may offer sales discounts. For example, a company may offer "2%/10, net 30." This means if a customer purchases products and pays within 10 days, they can take 2% off the total price. Otherwise full payment is due within 30 days. This is equivalent to the customer earning 36% annually just for paying on time (.02 times 18, the number of 20 year periods in a year). Nonetheless, it is likely that a certain percentage of customers will not pay on time, and estimates of uncollectible accounts should be made when it can be reasonably estimated. Estimates are usually based on historical uncollectibles. Since Sunny Sunglasses is new in the business, it has estimated that roughly 1% of credit sales will be uncollectible based on industry averages. This comes out to approximately $700 a year, as seen on the
2007 Income Statement,
and the
December 31, 2007 Balance Sheet.
Net Receivables at year end equals $21,200. Since Sunny Sunglasses Shop started business in January of 2007, there is no beginning balance. Net Credit Sales for the year were $70,000. Plugging the numbers into the formula, we get 6.6.
Alternatively, businesses may calculate Accounts Receivable Turnover in a two step process as follows:
In both Accounts Receivable Turnover and Average Collection Period calculations above, Accounts Receivable is net receivables, i.e. Accounts Receivables less any allowance for bad debts. The Average Collection Period can be translated to Inventory Turnover by dividing by 365 by the Average Collection Period, or 365/54 = 6.8. Since many companies do not disclose total sales on credit, many companies use this method to determine Accounts Receivable Turnover. Make sure, when comparing turnover ratios, that the same sales type is used when calculating receivable turnovers (credit sales or total sales). The next step is to add meaning to these numbers by comparing them with the industry averages:
Sunny Sunglasses has an average collection period of 54 days after one year of operations. It also has a low Accounts Receivable Turnover Ratio compared to its main competitor and especially the industry average. This account balance should not be increasing very much over the course of the year if the company is to remain within industry standards. If Sunny Sunglasses has an Achilles Heel in its profitable operations, it may be the low Accounts Receivable Turnover. In fact, we can check what the balance of A/R should be throughout the year to stay competitive with industry standards. Simply use the Average Collection Period above to calculate what the Accounts Receivable balance should be to stay within a given collection period (e.g. 15 days, 30 days, 45 days, 60 days, or 90 days). AR Balance/Average Sales per Day = Average Collection Period Days AR Balance = Average Sales per Day x Average Collection Period Days AR Balance = $395 x y $395 x y where y = number of collection days
If payment terms are within 60 days, the balance needs to stay at or under $24,000 assuming sales average $395 a day. Greater sales allow for higher receivable balances within the collection time frames. The company should monitor Accounts Receivable balances during the year, and compare Accounts Receivable Turnover per quarter and per year to ensure turnover does not decrease from period to period.
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