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Receivables Turnover Ratio defines the systematic use of ratios to interpret financial statements considering an organisation's operating performance & financial position. It encompasses comparison for a thoughtful and effective interpretation of a financial statement. Each ratio is categorised in any of the following ways:
The receivables turnover ratio can measure the times a firm collects the average balance. It's the quantification of an establishment's efficacy in gathering balances from clients in addition to managing the line of credit procedure.
What Is the Accounts Receivables Turnover Ratio?
Receivables turnover ratio and definition are already mentioned above. Now that you have learned its definition – let's learn the other aspects of this ratio. In simple words, the Accounts Receivables Turnover ratio is also called the debtors turnover ratio.
It's the total times an average debtor has converted into cash during one fiscal year. It is known as the efficiency ratio, and its prime purpose is to measure an organisation's ability to save revenue. It is beneficial in interpreting the efficiency of a company in using its assets.
Understanding ReceivablesTurnover Ratios
If there's a high ratio, it indicates that the collection tactics are effective, with customers paying debts faster. But the low ratio occurs due to inefficient collection procedures and improper credit policies. At times, even customers fail to be financially creditworthy or viable. Investors need to be mindful of some firms using total sales instead of net sales. Their motive behind this use is to calculate ratios that can inflate the overall results.
Now coming to the point of understanding the accounts receivable turnover. In short, accounts receivable are interest-free & short-term loans. Firms use them for customers. So, when an establishment generates sales to clients, it might extend 30-60 days. That means the client benefits from paying for a product within 30-60 days.
A receivables turnover ratio evaluates the efficacy of a company in collecting the receivables or credit extending to consumers. In addition, this ratio also evaluates the times the receivables of the firm are changed to the cash amount. All in all, the ratio can be calculated quarterly, monthly, or annually.
Receivables Turnover Ratio Formula & Calculation
Want to calculate the ratio? If yes, you require following the given steps:
First: Evaluate the Credit Sales
Assessing credit sales is the first consideration that you require to keep in mind. The figure includes the total credit sales minus the returns or allowances. That way, you can find the credit sales number in the annual income statement or even the profit/loss account.
Second: Assess The Accounts Receivable
As soon as you have figured out the credit sales, the second thing considering the accounts receivable turnover formula is to figure out the accounts receivable. It refers to the amount of money owed to any business by the customers.
To find the receivable amount, you must take the accounts receivable number at the year's beginning and add it to the accounts receivable value at the year's end. Divide the number by two and find the average. That's how you can find the accounts receivable numbers
Third: Apply the Formula
Soon after finding the values, you have to use the formula for accounts receivable turnover. Then, divide the credit sales by the accounts receivable average amount to calculate the ratio.
What's The Difference between Low and High Turnover Ratio
The high amount indicates the company's accounts receivables collection, which is efficient. It consists of customers paying their debts faster. A high turnover ratio may indicate the company's operation on the basis of cash.
The high ratio may suggest the firm is conventional in terms of extending credits to the customers. The fact is that credit policies may be beneficial as they help organisations refrain from extending credits to consumers who are unable to pay timely.
On the contrary, the low ratio is because of an inadequate collection procedure. Also, it may occur due to the creditworthiness of customers or improper credit policies.
This turnover ratio indicates the company reassesses the credit policies so that timely collection occurs considering the receivables. If a first has a low ratio and improves the collection procedure, it may contribute to a cash influx from collecting old credits or receivables.
Receivables Turnover Ratio and Its Significance
The ratio can be beneficial to a firm because the ratio evaluates the following aspects:
● How excellently the company collects the credit sales: With the company processing the receivable balances more speedily, it gains capital faster.
● Collateral opportunities of the company: Some might leverage accounts receivable as collateral. If the receivable activity is strong enough, the firm may borrow a fund.
● The ability to make capital investments: The firm might project the amount of cash it has for the future if it can quickly exchange receivable balances into cash.
● The sufficiency of a company in assessing clients' credit: With a low turnover ratio, a company might not be able to review the client's creditworthiness. A slower turnover leads to clients getting insolvent, so they cannot pay the amount.
● Its performance compared to the competitors: While measuring the competitors' financial ratios, a firm understands whether it outshines others or falls behind.
In the above ways, the accounts receivables turnover ratio proves to be beneficial for businesses.
What Are the Receivables Turnover Ratio Limitations?
A few firms use sales rather than net sales while calculating the ratio. It results in an inaccurate calculation that makes an organisation's calculation seem higher. One more limitation is the accounts receivable vary all year round.
While choosing the beginning & ending values, one should carefully calculate the average accounts receivable to reveal the performance of the company.
The Best Receivables Turnover Ratio Example
Suppose a company XYZ has made net credit sales of INR 100,000 for one year. It had a sales return amount of INR 20,000 with the accounts receivables amount of INR 25,000. Then what is the Receivables Turnover Ratio of the company XYZ?
To find out the net credit sales, you require following this formula:
Net Credit Sales = Sales ( - ) Sales returns
So, INR 100,000 - INR 20,000 = INR 80,000
As per the given question, the average accounts receivable is INR 25000 (as mentioned already).
So, the Accounts Receivables Turnover ratio happens to be Net credit sales divided by Average accounts receivable, i.e.:
80,000/25,000 = 3.2
So, the amount of accounts receivables turnover ratio happens to be 3.2.
So, this post has elucidated the definition of the receivables turnover ratio, calculation tips, examples, limitations, and more. As you have an insightful understanding of it, please learn what customers usually ask about accounts receivable turnover through the given FAQs:
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Frequently Asked Questions
With a decent accounts receivable turnover ratio, companies strive for a minimum of 1.0 ratio. This ensures it collects the complete full amount of the average accounts receivable once during the period.
A higher number is always better because it means that the customers pay timely and the firm is great at collecting.
Low receivable turnover is caused by a nonexistent or loose credit policy, a massive proportion of customers having financial issues or an inadequate collection.
A high ratio indicates that the firm's accounts receivable collection is efficient & it has a great proportion of quality customers paying debts on time. In addition, a high receivables turnover ratio also indicates that the firm operates on cash.
If the ratio is 10, it usually indicates that the average accounts receivable gets collected within 36.5 days
The average accounts receivable refers to the sum of starting & ending receivables over a timeframe (usually annually, quarterly, or monthly) and is divided by two. The accounts receivable turnover ratio is used for making balance sheet forecasts.