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 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 accounts receivable turnover ratio.
In this article
- Mathematical Formula for Receivables Turnover Ratio
- Example of Receivables Turnover Ratio
- What does High Receivables Turnover Indicate?
- What does Low Receivable Turnover Indicate?
- Various Differences between Asset Turnover and Receivables Turnover
- Benefits of Tracking Receivables Turnover Ratio
- Disadvantages of Accounts Receivable Ratio
Mathematical Formula for Receivables 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
Example of Receivables Turnover Ratio
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 was 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.
What does High Receivables Turnover Indicate?
A high receivables turnover ratio can indicate one or more of the following facts regarding a business –
- Efficient collection of accounts receivables.
- A majority of customers who tend to clear their dues on time.
- The business follows a conservative approach when extending credit to customers, taking care to offer such advances to those who are able to settle dues on time only.
- A high receivables turnover ratio can also be indicative of the fact that a company conducts its businesses mostly using a cash basis.
While 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.
What does Low Receivable Turnover Indicate?
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.
Various Differences between Asset Turnover and Receivables Turnover
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.|
Benefits of Tracking Receivables Turnover Ratio
Keeping an eye on this ratio can offer significant insight into a company’s credit policies; more specifically –
- Viability of such policies.
- Screening customers to determine the creditworthy ones from the others.
- Better effectiveness when it comes to dunning or collecting payment owed from customers.
- Punctuality in clearing open invoices.
- Identifying how the credit process can be implemented better, reducing delays in account receivables.
Still, the process has some limitations as well. Companies should keep such drawbacks in mind when looking at the receivables turnover ratio.
Disadvantages of Accounts Receivable Ratio
- Companies often use their total sales instead of their net sales when calculating this ratio. This can be done in a bid to inflate the results knowingly or unknowingly.
- Secondly, accounts receivable can vary throughout the year, especially for businesses selling seasonal goods. Thus, at times with higher receivables, a company can struggle to collect the cash effectively. However, at other time, it may manage to do the same easily.
- Results can be particularly misleading when the chosen period spans over a significant period, say 6 months or a year. A better option would be to calculate the ratio for each month in a 12-month period to avoid any misrepresentation of data due to seasonal gaps.
- In some cases, the poor receivables for a company are not a result of mismanagement of credit policies but that of other factors. For instance, issues in distribution may be preventing customers from acquiring the correct goods, thereby leading to non-payment of dues.
Thus, receivables turnover ratio, like any other business metric, has some caveats. Company management should know how to use it and how to perceive the date from such measurements.