Discuss the accounts receivable turnover ratio

Answer 1

Accounts Receivable Turnover

The rate at which accounts receivable turn over indicates how quickly a firm collects cash. The accounts receivable turnover ratio equals sales revenue divided by average accounts receivable during the period. In theory, the numerator should include only sales made on account if the objective is to measure how quickly a firm collects its accounts receivable. Most firms, except some retailers that deal directly with consumers (such as fast food outlets), sell their goods and services on account. Other firms, sell both for cash and on account. Such firms seldom disclose the proportions of cash and credit sales in their financial statements or notes. Thus, the analyst uses sales revenue in the numerator of the accounts receivable turnover ratio, recognizing that the inclusion of sales made for cash will increase the numerator and thereby overstate the receivables turnover ratio. The accounts receivable turnover ratio therefore indicates how quickly a firm turns its sales into cash but not how quickly it collects its accounts receivable.

The analyst often expresses the accounts receivable turnover in terms of the average number of days that elapse between the time the firm makes the sale and the time it later collects the cash, sometimes called days accounts receivable are outstanding or days outstanding for receivables. To calculate this ratio, divide 365 days by the accounts receivable turnover ratio.

Most firms that sell to other businesses, as opposed to consumers, sell on account and collect within 30 to 90 days. Interpreting any particular firm's accounts receivable turnover and days receivable outstanding requires knowing the terms of sale. If a firm's terms of sale are "net 30 days" and the firm collects its accounts receivable in 45 days, then collections do not accord with the stated terms. Such a result warrants a review of the credit and collection activity to ascertain the cause and to guide corrective action. If the firm offers terms of "net 45 days," a days receivable outstanding of 45 days indicates that the firm handles accounts receivable well.

Many firms sell to customers on account as a strategy to stimulate sales. Customers may purchase more willingly and purchase more if they know they need only sign their name. Such firms may also encourage customers to delay paying for their purchases as a means for the selling firm to generate interest revenue through finance charges on the unpaid amounts. Thus, comparing accounts receivable turnovers over time or between firms requires an analysis of the growth rate in sales, the amount of interest revenue generated, the cost of administering the credit-granting activity, and the losses from uncollectible accounts.