Tuesday, June 26, 2018

Activity Ratios and Accounts Receivable Turnover

“Activity ratios” measure "turnover" or the rates at which current assets and current liabilities are used-up or paid-off through ordinary business operations.  Quicker turnover ratios generally imply greater efficiency and better management.  The first such ratio is the accounts receivable turnover ratio:

          Accounts Receivable Turnover = Annual Net Revenue
                                                               Accounts Receivable

Accounts receivable turnover represents the average number of times per year that trade receivables "turn over" or are converted to cash.  Higher, more rapid turnover is favorable, since sales on credit are being converted to cash more quickly.  Lower, less rapid turnover is unfavorable since default becomes more likely as receivables remain uncollected, and since conversion to cash is necessary to service obligations or to earn interest.

A problem with this ratio is the fact that it compares accounts receivable at a single point in time to an entire year of sales.  If the accounts receivable balance is unusually high or low on the date of the financial statements due to seasonal variations or other factors, then this measurement may not provide an accurate picture.  Substituting average receivable balances over the year in the denominator, may help correct this.

Another potential problem exists when cash sales represent a large percentage of total revenues.  The ratio will be very favorable in this case.  A more useful measure may be taken by considering only credit sales in the numerator.  Such a ratio is probably best used only in comparison with the company’s own historical turnover and with the actual payment terms the business requires of its customers.

Another way to look at accounts receivable turnover is in days:

          Days Receivables Outstanding=               365                           
                                                                Receivables Turnover Ratio

This ratio expresses the average length of time in number of days between sales and the cash collection of receivables.  The average number of days that receivables are outstanding can seem like a more intuitive measure than turnover expressed in number of times per year.  In this case, a lower value (or fewer days) is favorable because it represents more rapid turnover.

For Smith Heating and Cooling, Inc., accounts receivable turnover is 11.27 times per year, and the average number of days that receivables are outstanding is 32.39.  To put these numbers into better context, an analyst would compare them to receivables turnover from prior years, receivables turnover from similar businesses, and the company’s payment terms.  If Smith Heating and Cooling requires its customers to pay in thirty days, then receivables turnover is a bit slow.  If some customers pay cash at the time of service, then receivables collection may be really slow for those customers who pay on account.

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