Accounts Receivable Turnover Ratio and Measuring Efficiency

Those familiar with the accounting world know all too well that this numbers-based profession is chock full of ratios. These ratios tell the story of how healthy a business is, indicating many different things, such as profitability, liquidity, and efficiency, which we will be discussing today.

Our topic today is the accounts receivable turnover ratio, and it takes into account a business’ sales revenue and their average accounts receivable, and tells how efficiently they are being used. If you’re interested in the mathematical aspects of the ratios found in the accounting profession, this course on fundamental financial math, along with this article on accounting ratios will provide a solid foundation to further explore these subjects.

The Formula

Accounts Receivable Turnover Ratio = Net Credit Sales/Average Accounts Receivable

Let’s analyze this formula by breaking down its component parts. First, we have net credit sales, which can be found on the income statement. The reason net credit sales are used instead of net sales, is that cash sales do not create receivables. Only credit sales result in a receivable, which is why cash sales are left out of the equation. Net sales refers to sales minus any returns or refunds.

Average accounts receivable can be calculated by adding the receivables at the beginning and ending of the year, then dividing this amount by two. These receivable amounts can be found on the balance sheets from the first and last days of the accounting period, respectively. To learn more about the balance sheet and income statement, this course on interpreting financial statements will familiarize you with these important accounting tools.

Using the Ratio

Now that you know what figures go into determining the accounts receivable turnover ratio, let’s discuss it a bit further. This ratio is known as an efficiency, or activity, ratio, and these efficiency ratios are used to measure how well (or poorly) a company is able to utilize their assets in the generating of income. They are usually used by management to see where improvements need to be made, and may also be useful to outside investors and creditors curious as to the how profitable and efficient the company’s operations are.

Th accounts receivable turnover ratio is used to measure how efficient a company is in collecting its credit sales from customers. The resulting number that the ratio gives you indicates how many times the business is able to collect its average accounts receivable over the course of a year. Usually a higher ratio is favored over a smaller one, which indicates that the business is running efficiently. A number that is too high is suspect, however, showing outside creditors that the business may have very strict credit terms. This ratio is normally calculated annually, but in some situations may be done monthly or even quarterly in order to illustrate any trends. As with all accounting ratios, there is no one perfect ratio amount that applies to all businesses. All industries are different, and one business’ great receivables turnover ratio might be another business’ worst nightmare.

The Ratio in Action

To completely clarify what it looks like to actually use this ratio, we will show you a brief example of this ratio in action. As we don’t have the space to include actual balance sheets and income statements, we will simply list only the amounts associated with working this ratio.

Sales for Phil’s Fish for the year ended December 31, 2009 were $937,720. There were refunds of 89,450 for the year. On January 1, 2009, at the beginning of the accounting period, Phil had accounts receivables of $52,623. At the end of period, on December 31, 2009, receivables were $39,899. What is Phil’s accounts receivable turnover?

1. First, because net sales is not provided for us, we must figure it out. Knowing net sales is sales minus any returns and refunds, we can figure it out by subtracting these figures: 937,720 – 89,450 = 848,270 in net sales.
2. Next, we must find the average accounts receivable: (52,623 + 39,899)/2 = 46,261 in average accounts receivable.
3. Finally, divide net sales by average accounts receivable:  848,270/46,261 = 18.33

Now, we don’t know if the fish business thinks 18.33 is a good turnover ratio, but Phil’s accountant will have a good idea. Hopefully we were able to clearly explain this somewhat simple but important accounting concept. If you’re a whiz at math, and enjoy the idea of telling a business’ story in numbers, check out this beginning course in financial accounting and this more advanced accounting course in order to get a good idea of what accounting is all about.