Decoding receivables turnover ratio: A comprehensive guide

The number of times a company collects the account receivable balance is known as the receivable turnover ratio. It indicates how effectively the company manages its line of credit and hence, is an important marker. This ratio points significantly to the functioning of the companies and is used to compare the performance of different companies within the same industry. 

In this article, we will look at the receivables turnover ratio in detail with its calculation, importance, and limitation. 

What is the receivables turnover ratio?

Account receivables can be understood as short-term loans that companies extend to their customers. They sell the product or services to the customer for which they can pay within 30 to 60 days. 

The ratio measures how efficient a company is in collecting its accounts receivables or the credit it extends to its customers. The receivables ratio also measures the number of times the credit is converted to cash during a specific period. Businesses usually calculate this ratio on a monthly, quarterly, or annual basis. 

Calculation of the receivables turnover ratio

The receivables turnover ratio formula is: 

Accounts receivable turnover ratio = Net credit sales/Average accounts receivable 

Net credit sales refer to the total amount of cash received by a company paid via credit. It also incorporates sales discounts and returns from customers. The net credit sales are usually calculated for a specific period every time. 

Average accounts receivable measures the average balance of accounts receivables. This is generally calculated by taking into account the average of the starting and ending accounts receivable balance. Like net credit sales, the average accounts receivable should also be calculated for a specific period. 

High vs low receivables turnover ratio

A high accounts receivable turnover ratio indicates that a company’s process of collecting credit is good and it has a good proportion of quality customers who pay the debts quickly. It might also indicate that a company operates more on a cash basis and is conservative about selling its products and services on a credit basis. 

The benefit of having fewer customers who take products on credit is that the company remains safe from customers who might not pay the dues. However, the downside is that offering less credit might make the customers take products from other companies. 

A low accounts receivables turnover ratio indicates that the company has an inadequate collection process and quality customers who do not pay their dues on time or have bad credit policies. A low account receivables ratio reflects poorly on businesses and indicates that they must work on their collection and credit policies. 

Importance of receivables turnover ratio

With an understanding of what is a receivable turnover ratio and how to calculate the receivables turnover ratio, let us now look at its importance. The key reasons why businesses calculate this ratio include: 

• Collateral opportunities: Some companies can use their accounts receivable measure as collateral to take loans. The better the accounts receivable ratio, the better the opportunities for a company to borrow funds. 

• Large capital investments: With the ratio calculator, the company can forecast how much cash it will have in the future. With this cash calculation, they can then decide when they will be able to make large capital investments in the future. 

• Overall performance: By calculating the accounts receivable ratio from time to time, businesses can see their performance growth over some period. 

• Competitor analysis: By comparing the ratio for different companies over time in the same industry, businesses can determine how well they are performing in comparison with their competitors. 

• Creditworthiness judgment: If the rate is low, it means that the company is not assessing the creditworthiness of its customers thoroughly. As against this, a high accounts receivables turnover ratio indicates that the company is doing a thorough analysis of its customer’s creditworthiness. 

All these factors can be judged by the receivables turnover ratio. As a result, it is an important marker in determining the effectiveness of the company’s operations. 

Limitation of receivables turnover ratio

While the advantages of calculating the receivables turnover ratio are several, certain disadvantages must be considered. Sometimes businesses use the total sales instead of net sales while calculating the ratio. This makes the trade receivables turnover ratio appear higher than it is. 

Another limitation is that accounts receivable look different throughout the year, especially for companies that have a seasonal business. The seasonal gaps must be studied and calculated in a way that still showcases the actual company results. 

Conclusion 

The accounts receivable ratio measures the total number of times a business collects its receivable balance within a period. The ratio can help determine whether the business is efficiently managing its credit sales or not. If the ratio is low for a long time then it means the company needs to work on its credit and collection policies. 

However, keep in mind the limitations of the receivables turnover ratio interpretation

and its fluctuations to account for the actual ratio and make informed decisions. To know more, read StockGro blogs.

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