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Ratio analysis refers to the systematic use of ratios to interpret the financial statements in terms of the operating performance and financial position of a firm. It involves comparison for a meaningful interpretation of the financial statements.
In view of the requirement of ratios to be reported in a financial report, the ratios are classified into the following broad categories:
Turnover ratios are also referred to as activity ratios or efficiency ratios with which a firm manages its current assets. The following ratios can be calculated to judge the effectiveness of the asset's use.
In this article, we will discuss on accounts receivable turnover ratio.
Accounts Receivables Turnover ratio is also known as debtors turnover ratio. This indicates the number of times average debtors have been converted into cash during a year. This is also referred to as the efficiency ratio that measures the company's ability to collect revenue. It also helps interpret the efficiency in using a company's assets in the most optimum way.
The receivables turnover ratio is determined by dividing the net credit sales by average debtors.
Debtor Turnover Ratio = Net Credit Sales / Average Trade Debtors
The aggregate amount of sales or services rendered by an enterprise to its customers on credit. The terms gross credit sales and net credit sales are sometimes used to distinguish the sales aggregate before and after deduction of returns and trade discounts. The concept of net credit sales is an indicator of the total amount of credit that a company is granting to its customers.
A trade debtor is a person from whom amounts are due for goods sold or services rendered or in respect of contractual obligations. Also termed as a debtor, bills receivables or account receivable.
Trade debtor includes sundry debtors and bill’s receivables and the formula to determine average trade debtors is given below:
Average trade debtors ( Opening + Closing balances / 2 )
Note: When any information about credit sales, opening and closing balances of trade debtors is not available then the ratio can be calculated by dividing total sales by closing balances of trade debtor
Debtor Turnover Ratio = Total Sales / Trade Debtors
The first part of the accounts receivable turnover formula calls for net credit sales, or in other words, all of the sales for the year that were made on credit (as opposed to cash). This figure should include the total credit sales, minus any returns or allowances. We should be able to find the net credit sales number in the annual income statement or Profit & Loss a/c.
Once we have the net credit sales figure, the second part of the accounts receivable turnover formula requires the average accounts receivable.
Accounts receivable refers to the money that’s owed to a business by its customers. In order to find the average accounts receivable, we will have to take the number of your accounts receivable at the beginning of the year, add it with the value of your accounts receivable at the end of the year, and divide by two to find the average. We should be able to find the necessary accounts receivable numbers on the balance sheet.
Once we have these two values, we will be able to use the accounts receivable turnover formula. And then we will divide the net credit sales by the average accounts receivable to calculate the accounts receivable turnover ratio, or rate.
Let’s say MAX Ltd., made 100,000 Indo rupiah in net credit sales for the year and had sales returns amounting to 20,000 Indo rupiah, with average accounts receivable of 25,000 Indo rupiah. What is the Receivables Turnover ratio of MAX Ltd?
Step 1 : Net Credit Sales = Sales ( - ) Sales returns
In the given example it works out to 80,000 Indo rupiah
Step 2: Average accounts receivable (already given in the example as 25000 Indo rupiah )
Step 3 : Divide = Net credit sales/ Average accounts receivable
In the given example, 80,000/25,000 = 3.2 (Accounts Receivables Turnover ratio)
The accounts receivable turnover ratio is an important indicator to assess a company's overall financial health. A high ratio indicates a company's ability to:
For example: A company with a ratio of 2, which is inherently not such a “high” number, will appear to be performing considerably better if the average ratio for its industry is two. It is important to also understand the ratio as per industry standards, as they vary from segment to segment. A number which probably considered as high in one business segment may not be the same for another. Thus, a business owner must do a careful analysis to derive a number that would be beneficial for his business against the competitors.
A high accounts turnover ratio is considered desirable by companies, as it suggests that the company’s collection process to collect revenue is efficient, the company enjoys a high-quality customer base, or that the company maintains a conservative credit policy. A low accounts receivable turnover is an indicator that the company's overall financial health may not be that great and can suggest a poor collection process, extending credit terms to bad customers, or extending its credit policy for too long.
Some of the most common limitations of accounts receivables turnover ratio are:
Instead of using net credit sales, some companies may use total sales in the numerator. In such a scenario, if the number under cash sales is high, the amount of turnover will also appear to be high, which is misleading, as the turnover ratio isn't accurate
When the accounts receivable turnover ratio is too high, it may indicate that the company's credit policy is way too stringent. Here it suggests that the credit manager only allows credit sales to the most creditworthy customers, and letting competitors with more flexible credit policies take away other sales
It's possible that a low receivable turnover rate isn't the fault of the credit and collections department. Instead, it's possible that mistakes made elsewhere in the organisation are preventing payment. Customers may refuse to pay the corporation if the goods are damaged or the wrong goods are supplied, for example. As a result, the blame for a poor measurement result can be dispersed among a company's several departments.
The AR turnover ratio depends on which industry your business belongs to. Depending on the industry, you can assess what's best for your business. If an average ratio of a specific industry, say manufacturing is 10, a company that belongs to that business segment must have that ratio. However, it could be as low as 5 for another industry, and still can be considered as a high AR for that sepcific segment.
A receivable turnover of 10 means that the company's financial health as per that industry is good and it can manage its short term debts and also has a good credit policy for its customers.
Considering most companies collect within 30 days, the average collection period would thus be 36-37 days.
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