Like banks, companies extend credit to consumers. This allows for the immediate purchase of goods with payment in the future. Accounts receivable turnover measures how effectively companies turn credit sales into cash.
What Is Accounts Receivable Turnover?
Like many other measures in financial analysis, accounts receivable turnover has a ratio expression. This is a measure of how efficiently a firm uses its assets and financing structure.
Accounts Receivable Turnover = Net Credit Sales/Average Accounts Receivable
Furthermore, average accounts receivable is the value of accounts receivable at the beginning of the period plus the ending period accounts receivable divided by two. Evaluation typically takes place annually, although quarterly is also common.
Accounts Receivable Turnover Analysis
Other than banks, companies who extend credit essentially lend money for free. For example, retailers typically do not charge interest on their inventory sales. Furthermore, retailers use this practice as it increases the inventory turnover. This is a profitable strategy if consumers pay in a reasonable time frame. Also, the time value of money implies that companies lose money on this deal. However, without extending credit, the sale may not exist.
For example, imagine a company had net credit sales during the year of $500,000. If beginning receivables equaled $25,000 and ending receivables equaled $30,000, then average accounts receivable = (25,000 + 30,000)/2 = 27,500. The accounts receivable turnover then = $500,000 / 27,500 = 18.2. This shows that the company collects accounts around 18 times per year. Additionally, dividing 365 days in a year into this number shows how long it took to collect during the year. Here, the average consumer took 365/18.2 = 20 days to pay.
Finally, accounts receivable turnover is industry specific. The number tells different stories about a company. It implies some companies operate more on cash, other times it shows that the company serves quality customers. Some believe that an overly pristine ratio shows conservative lending tactics by the company that, if more aggressive, would increase sales.
In conclusion, accounts receivable turnover measures the operating efficiency of companies. Extending credit is an effective means of moving inventory. Companies that manage this to perfection enjoy higher sales and consequently higher quarterly profits.