“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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