Receivables turnover ratio (also known as debtors turnover ratio) is computed by dividing the net credit sales during a period by average receivables.
Accounts receivable turnover ratio simply measures how many times the receivables are collected during a particular period. It is a helpful tool to evaluate the liquidity of receivables.
Two components of the formula are “net credit sales” and “average trade accounts receivable”. It is clearly mentioned in the formula that the numerator should include only credit sales. But in examination questions, this information may not be given. In that case, the total sales should be used as numerator assuming all the sales are made on credit.
Average receivables are equal to opening receivables (including notes receivables) plus closing receivables (including notes receivables) divided by two. But sometimes opening receivables may not be given in the examination questions. In that case closing balance of receivables should be used as denominator.
The data of a trading company is given below:
|Accounts receivables – opening||$400,000|
|Accounts receivables – closing||$250,000|
|Notes receivables – opening||$150,000|
|Notes receivables – closing||$200,000|
Required: How may times (on average) company collects accounts receivables?
Hint: Compute accounts receivable/debtors turnover ratio.
= $3,000,000* / $500,000**
On average, the company collects its receivables 6 times a year.
* Credit sales:
$5,500,000 – $2,500,000 = $3,000,000
**Average tread receivables:
(400,000+250,000+150,000+200,000)/2 = 500,000
Significance and Interpretation:
This ratio is very helpful when used in conjunction with short term solvency ratios i.e., current ratio and quick ratio. Short term solvency ratios measure the liquidity of the company as a whole and accounts receivable turnover ratio measures the liquidity of accounts receivables.
There is no rule of thumb to interpret this ratio. Analysts can compare the ratio with industry’s standard. Generally, a high ratio indicates that the receivables are more liquid and are being collected promptly. A low ratio is a sign of less liquid receivables and may reduce the true liquidity of the business in the eyes of the analyst even if the current and quick ratios are satisfactory.