Receivable Turnover
Receivable turnover (often called “accounts receivable turnover” or “debtors turnover”) is a financial metric used to measure the effectiveness with which a company manages its accounts receivable. It indicates how many times, on average, a company collects its average accounts receivable balance during a specified period, typically a year.
The formula to calculate receivable turnover is:
Receivable Turnover = Net Credit Sales / Average Accounts Receivable
Where:
- Net Credit Sales is the total sales made on credit during the period, minus any returns or allowances.
- Average Accounts Receivable is the average balance of accounts receivable during the period. It is typically computed by adding the beginning and ending accounts receivable balances for a period, and then dividing by two.
The receivable turnover ratio provides insight into the company’s credit policy and debt collection success. A higher ratio indicates that the company collects its receivables more frequently during the period, suggesting effective credit and collection processes. Conversely, a lower ratio may indicate that the company has a higher proportion of uncollectible accounts or that it offers more lenient credit terms.
In addition to the receivable turnover ratio, businesses often compute the average collection period to determine, on average, how many days it takes to collect receivables:
Average Collection Period = Number of Days in the Period / Receivable Turnover
For instance, using a 365-day year, if the receivable turnover is 5, then the average collection period would be 365 / 5=73 days. This means, on average, it takes the company 73 days to collect its receivables.
Example of Receivable Turnover
Let’s consider an example to better understand the concept of receivable turnover.
ABC Company Financial Data:
- Net Credit Sales for the year: $1,200,000
- Beginning of the year Accounts Receivable: $150,000
- End of the year Accounts Receivable: $250,000
Step 1: Calculate the Average Accounts Receivable.
Average Accounts Receivable = Beginning AR + End AR / 2
Average Accounts Receivable = 150,000 + 250,000 / 2
Average Accounts Receivable = 200,000
Step 2: Calculate the Receivable Turnover.
Receivable Turnover = Net Credit Sales / Average Accounts Receivable
Receivable Turnover=1,200,000 / 200,000
Receivable Turnover = 6
This means that ABC Company collected its average accounts receivable 6 times during the year.
Step 3: Calculate the Average Collection Period (optional).
Average Collection Period = 365 days / Receivable Turnover
Average Collection Period = 365 / 6
Average Collection Period = 60.83
So, it takes ABC Company, on average, approximately 61 days to collect its receivables.
Interpretation:
With a receivable turnover of 6, ABC Company seems to be effectively managing its credit sales and collections process since it collects its average receivables six times a year. However, it’s essential to compare this metric with industry averages or the company’s past performance to get a comprehensive understanding. If most companies in the same industry have a much higher turnover, it might indicate that ABC Company’s collection process is relatively slow.
