Many companies sell goods or services on account. This means that a customer purchases goods or services from a company but does not pay for them at the time of purchase. Payment is usually due within a short period of time, ranging from a few days to a year. These transactions appear on the balance sheet as accounts receivable.
The total receivables due can vary considerably from one period to the next. Sales on account will increase the accounts receivables balance, while payments from customers will decrease the accounts receivables balance. The volume of sales has a significant impact on accounts receivables. An increase in sales volume usually results in an increase in accounts receivables.
It is important to collect accounts receivables as quickly as possible. The longer it takes to collect outstanding receivables, the more likely it is that the account may never be paid. Receivables also tie up cash, which means there is less money available for use in operations, paying dividends, or for other investing activities. The accounts receivable turnover ratio measures how many times, on average, accounts receivables are collected in cash during the year.
Accounts Receivable Turnover
This ratio is computed by dividing net sales by the average net accounts receivable. Ideally, only the sales on credit should be used in the numerator, but many companies only report net sales, therefore, it is acceptable to use net sales.
In order to arrive at an average net account receivable, it may be necessary to add the receivables balance at the beginning of the year to the receivables balance at the end of the year and divide by 2. As an example, if the accounts receivable balance was $138,000 at the beginning of the year, and $114,000 at the end of the year, the average net accounts receivable is $126,000 ($138,000+$114,000/2).
Therefore, if the net sales for the year are $1,354,000 and average accounts receivable is $126,000, the accounts receivable turnover is 10.7 ($1,354,000/$126,000). This means that the accounts receivables are being collected in cash approximately 10.7 times per year.
Generally, a higher ratio implies that a company is efficient in collecting its accounts receivables. A high ratio could also indicate that a company operates on a mostly cash basis. A low ratio is an indicator that a company may need to reassess its accounts receivables procedures in order to improve timely collections of accounts receivables. It is useful to compare this ratio against previous years, as well as against industry standards.
