Definition and explanation
Receivables turnover ratio (also known as debtors turnover ratio) is an activity ratio which measures how many times, on average, an entity collects its trade receivables during a selected period. It is computed by dividing the entity’s net credit sales by its average receivables for the period.
This ratio, together with average collection period ratio, indicates how quickly a business entity is able to convert its credit sales into cash and thus helps in evaluating the liquidity of receivables the business owns. Like some other activity ratios, receivables turnover ratio is expressed in times like 5 times per quarter or 12 times per year etc.
The commercial entities should determine their receivables turnover ratio from time to time because it is directly linked with the availability of cash, or its equivalent, which they can use to meet their day to day operating expenses as well as their short-term obligations.
Formula of receivables turnover ratio
Two components of the formula of receivables turnover ratio are “net credit sales” and “average trade receivables”. The formula states that the numerator should include only credit sales; however in examination problems, the examiners often don’t provide a separate breakdown of cash and credit sales. In that case, the students should use the total sales number given in the question as the numerator of the equation, assuming that all the sales have been made on account.
Average receivables in denominator part of the formula are equal to opening receivables balance plus closing receivables balance divided by two. If the opening receivables’ balance is not given in the question, the closing balance of receivables should be used as denominator. For the purpose of receivables turnover ratio, the students should bear in mind that opening and closing balances of receivables include the balances of both accounts receivable as well as the balances of all valid notes receivable that the entity holds at the beginning and end of the period. Let’s exemplify the calculation of receivables turnover ratio.
The selected data about sales and receivables from the opening and closing balances of Maria Trading Company is provided below:
- Cash sales: $1,250,000
- Credit sales: $1,275,000
- Accounts receivable – January 1, 2021: $200,000
- Accounts receivable – December 31, 2021: $125,000
- Notes receivable – January 1, 2021: $75,000
- Notes receivable – December 31, 2021: $100,000
Required: How may times on average the company collects its receivables? Hint: Compute receivables or debtors turnover ratio.
= 6 times
*Average tread receivables:
($325,000+$175,000)/2 = $250,000
Maria Company’s receivables turnover ratio is 6 times for the year 2021 which means the company on average has collected its receivables 6 times during the year. To analyze how efficient it has been in collecting its receivables during this period, the Maria can compare this ratio with its competing entities as well as with its own past years’ receivables turnover ratio.
Now we can use the Maria’s receivable turnover ratio to calculate its average collection period ratio which would reveal the average number of days the company takes to collect a credit sale. We can do so by dividing the number of days in a year by the receivables turnover ratio.
365/6 = 60.83 days
Maria’s average collection period, as computed above, is 60.83 days which means the company on average takes 60.83 days to collect a receivable. Whether a collection period of 60.83 days is good or bad for Maria depends on the payment terms it offers to its credit customers. For example, if Maria’s credit terms are 90 days, then the average collection period of 60.83 days is perfectly fine, but if, on the other hand, its credit terms are 30 days, then an average collection period of 60.83 days would certainly be worrisome.
Significance and interpretation
Generally, a higher receivables turnover ratio indicates that the receivables are highly liquid and are being collected promptly. A low ratio, on the other hand, signifies less liquid receivables and may impair the entity’s liquidity position in the eyes of analysts, even if a short-term solvency metric like current or quick ratio exhibits a satisfactory number. A low turnover may also be caused by the entity’s own inabilities like following an inappropriate credit policy and having defects in collection process etc.
Receivables turnover ratio is more useful when used in conjunction with short term solvency ratios like current ratio and quick ratio. These short term solvency indicators measure the liquidity of the entity as a whole and receivables turnover ratio helps determine the quality of accounts receivable as individual current asset the entity holds.
No single rule of thumb exists to interpret receivables turnover ratio for all companies. An analyst or investor can evaluate an entity’s ability to collect its debtors by comparing its ratio with industry’s norm or with the ratio of other entities within the industry having similar business model, size and capital structure. In addition, he can also compare the ratio with the entity’s own past collection efficiency for his analysis.
Managers should continuously track their entity’s receivables turnover ratio on a trend line to observe the gradual ups and downs in turnover performance which can’t be revealed by a one time or occasional computation.
Limitations and issues with using receivables turnover ratio
Like other efficiency measurements, receivable turnover ratio suffers from a number of issues and limitation. Some of them are briefly discussed below:
- Receivables turnover ratio does not reflect the creditworthiness of individual receivables. The calculation of this metric is based on the average receivables for a selected period which can’t be solely relied upon for determining an entity’s ability to collect its credit sales. A proper evaluation of entity’s collection ability and the credit status of its customers require analysts to have a careful investigation of receivables aging report.
- A high turnover metric may indicate that the management is adopting an excessively conservative credit policy by which it allows credit sales to only highly creditworthy customers, driving away others to competitors. An entity with unnecessarily too restrictive credit policy may suffer from lost revenue, reduced profit and therefore slower growth.
- A low receivables turnover ratio does not necessarily reflect an inadequate credit policy or inefficiency on the part of collection personnel. Instead, it may be caused on account of negligence of staff working in other areas of the organization. An inefficient shipment and delivery process can be a major reason of delayed payments. For example, if faulty, broken, unfit or otherwise undesired items are frequently dispatched, the customers would certainly not accept them and refuse to make the payment until the the right products are delivered to them.
- Many seasonal businesses usually observe a significant variation in their receivables throughout the year. The analysts should therefore be careful in selecting the beginning and ending points while determining the average receivables balance of such businesses. A helpful approach for leveling any seasonal gaps in such situations is to compute the ratio for the full year and use the average ending balance of all the months as denominator of the formula. This is because an arbitrarily selected period might provide misleading or inadequate values for both numerator and denominator of the equation and the receivables turnover ratio derived from such values may not reflect the entity’s actual collection ability.
- Some companies deviate from the calculation illustrated above. Instead of net credit sales, they use the total sales value as numerator of the formula. While this approach may exhibit a slightly higher ratio number than it should actually be, the purpose may not be to conceal the fact or mislead the users. The analysts and investors should investigate the way the company has driven its ratio or they can compute the ratio independently on their own.