The account receivables turnover ratio determines how often a business collects its accounts receivable throughout a period of time, usually one year. The period of time can be adjusted as necessary, for instance the accounts receivable turnover ratio is often calculated on a month by month basis for comparison or statistical purposes.
Accounts Receivable Turnover Ratio Formula
Net Credit Sales (for a period of time) / the Accounts Receivable Average (for the same period of time) = Accounts Receivable Turnover Ratio
Accounts Receivable Turnover Ratio Video Tutorial With Examples
The higher the account receivables turnover ratio is, the more likely that the business has an aggressive collections policy and extends credit cautiously, while a lower ratio suggests that the business can improve its collections department or is extending credit too frequently. A low ratio also suggests that a business may need to collect on old accounts receivable that may be tying up working capital.
A low accounts receivable turnover ratio does not necessarily mean that a business is having problems with collecting or has too lenient of a credit policy. For example, the business may have problems with customer service or product quality which is resulting in excessive returns. Excessive returns will lower net credit sales which in turn lowers the turnover ratio. The company can improve their turnover ratio by improving their customer support and product quality which will reduce return rates.
Accounts Receivable Turnover Ratio Formula Video Example 1
Accounts Receivable Turnover Ratio Formula Written Example 1
Mark’s Bike Shop sells bicycles and biking gear. He allows his customers to have accounts to purchase their gear or bikes. On January 1, 2012 Mark’s shop had a $20,000 accounts receivable balance. On December 31, 2012 Mark had a $40,000 accounts receivable balance. During that time period he had $20,000 in returns and $140,000 in gross credit sales.
In this example, the Net Credit Sales is found by subtracting gross credit sales from returns, which is $140,000 – $20,000 = $120,000. The accounts receivable average is found by averaging the balance from January 1, 2012 with the balance from December 31, 2012. This is ($20,000 + $40,000) / 2 = $30,000.
Finally the accounts receivable turnover ratio can now be calculated by dividing net credit sales by the accounts receivable average. This is $120,000 / $30,000 = 4. This suggests that Mark collects receivables 4 times per year or about once every 91 days – it takes him about 91 days to receive cash after he makes a credit sale.
Accounts Receivable Turnover Ratio Formula Written Example 2
In the second example, the accounts receivable turnover ratio is calculated for a period of one month. Sarah’s Outdoor Supply Company sells outdoor and camping gear and allows customers to have credit accounts. Sarah’s accounts receivable balance on January 1, 2012 was $20,000 and on January 31, 2012 it was $30,000. During that period of time her store had $30,000 in gross credit sales with $5,000 in returns.
Calculating the turnover ratio for January 1 to January 31, 2013 is the same procedure as before. Net credit sales is found by subtracting gross credit sales from returns, or $30,000 = $5,000 = $25,000. The accounts receivable average is $20,000 + $30,000 / 2 = $25,000. So the turnover ratio for this period is $25,000 / $25,000 = 1.
This suggests that Sarah is collecting from her accounts receivable about once every month, and if this pace continued for the rest of the year the ratio would be around 12. This also suggests that her company has good collection or credit practices or satisfied customers who pay on time.
Keep in mind that the accounts receivable turnover ratio will vary based on the industry, and there are many factors that are used to determine if a ratio is considered “normal” for a particular industry. For instance, some service businesses may collect quarterly as a part of their normal collection practices and this may be standard for their industry, so their turnover ratio would often be at or around 4.
Since there are many potential factors involved, is also helpful to compare numbers from competing companies to help determine the “normal” ratio for an industry.