Businesses often need to extend credit to their clients, whereby the latter receive the inventory without clearing ensuing bills immediately. The management of a company is responsible for collecting such outstanding receivables within a specified time, failing which a business’s cash flow suffers.
The metric used to measure the efficiency at which such debts are extended, and concerned dues are collected is known as the receivables turnover ratio. The receivables ratio is indicative of how well a company can manage these short-term credits.
Besides receivables turnover, this measurement of efficiency is also known as the accounts receivable turnover ratio.
To find out the receivables turnover ratio for a particular company, two factors are essential – net credit sales and average accounts receivable. Thus, the receivables turnover ratio formula is –
Receivables turnover ratio = Net credit sales/average accounts receivable
One can acquire the average accounts receivable by adding the accounts receivable at the beginning and the end of the specified period and dividing the result by two.
For instance, if the desired period for receivables turnover ratio is the 2nd quarter in a particular year, one would need to add the actual receivables at the start of this quarter and the end of it, before dividing the sum by 2.
Similarly, net credit sales refer to the revenue generated through sales, which were completed on credit after subtracting the returns from customers. Thus,
Net credit sales = Gross credit sales – customer returns
With this receivables turnover formula in mind, consider the following example.
Mehta Group’s gross sales for the year ended December 31st, 2019 was Rs. 2 crore and returns from customers at that time were Rs. 20 lakh. At the start of this year, the accounts receivable was Rs. 30 lakh, while it was Rs. 20 lakh by the year-end.
From this information, calculating the receivable turnover ratio for Mehta Group would be simple.
Accounts receivable ratio = (Rs. 2 crore – Rs. 20 lakh)/ [(Rs. 30 lakh + Rs. 20 lakh)/2] = 7.2
Thus, Mehta Group collected 7.2 times its accounts receivables throughout 2019.
Companies can acquire accounts receivable turnover in days from this data as well. All they need to do is to divide 365 by the receivables turnover ratio. Therefore, in the case of Mehta Group, the receivable turnover in days is –
7.2/365 = 50.69 days.
This metric indicates that an average Mehta Group customer repays a credit to the company within 51 days.
A high receivables turnover ratio can indicate one or more of the following facts regarding a business –
While a conservative credit policy can help limit risk for a business, it can also force clients to seek the products or services from competitors who are ready to extend credit.
The low receivables turnover ratio indicates that the company in question is inefficient at collecting debt from customers. It can also mean that the business’s credit policies are improper. Alternatively, such a metric can also posit that a company’s customers are not creditworthy.
At any rate, any enterprise with a low receivable turnover proportion would need to rethink its credit extension policies.
The following table reveals some of the distinct points which differentiate account receivables turnover from asset turnover ratio.
|Factors||Asset Turnover Ratio||Account Receivables Ratio|
|Definition||This metric measures a company’s revenue against its assets.||It is a measure of the efficiency of a company to extend and collect the debt.|
|What it indicates||It shows how effectively a company is using its assets to generate revenue.||It reveals how effectively a company is able to manage debt to its clients and recover the said dues.|
Keeping an eye on this ratio can offer significant insight into a company’s credit policies; more specifically –
Still, the process has some limitations as well. Companies should keep such drawbacks in mind when looking at the receivables turnover ratio.
Thus, the receivables turnover ratio, like any other business metric, has some caveats. Company management should know how to use it and how to perceive the data from such measurements.