What is the 'Receivables Turnover Ratio'
An accounting measure used to quantify a firm's effectiveness in extending credit and in collecting debts on that credit. The receivables turnover ratio is an activity ratio measuring how efficiently a firm uses its assets.
Receivables turnover ratio can be calculated by dividing the net value of credit sales during a given period by the average accounts receivable during the same period. Average accounts receivable can be calculated by adding the value of accounts receivable at the beginning of the desired period to their value at the end of the period and dividing the sum by two.
The method for calculating receivables turnover ratio can be represented with the following formula:
BREAKING DOWN 'Receivables Turnover Ratio'
Receivable turnover ratio is also often called “accounts receivable turnover,” the “accounts receivable turnover ratio” or the “debtor’s turnover ratio.”
In essence, the receivables turnover ratio indicates the efficiency with which a firm manages the credit it issues to customers and collects on that credit. Because accounts receivable are moneys owed on a credit agreement without interest, by maintaining accounts receivable firms are indirectly extending interest-free loans to their clients. As such, because of the time value of money principle, a firm loses more money the longer it takes to collect on its credit sales.
To provide an example of how to calculate the receivables turnover ratio, suppose that during 2014 Company A had $800,000 in net credit sales. Also suppose that on the first of January it had $64,000 accounts receivable and that on December 31 it had $72,000 accounts receivable. With this information, one could calculate the receivables turnover ratio for 2014 in the following way:
$800,000 / [($64,000 + $72,000) / 2] = $800,000 / ($136,000 / 2) = $800,000 / $68,000 = 11.76
This number also serves as an indicator of the number of accounts receivable a company collects during a year. Because of this functionality, one can determine the average duration of accounts receivable during a given year by dividing 365 by the receivables turnover ratio for that year. For this example, the average accounts receivable turnover is 31.04 days (365 / 11.76).
Interpreting 'Receivables Turnover Ratio'
A high receivables turnover ratio can imply a variety of things about a company. It may suggest that a company operates on a cash basis, for example. It may also indicate that the company’s collection of accounts receivable is efficient, and that the company has a high proportion of quality customers that pay off their debts quickly. A high ratio can also suggest that the company has a conservative policy regarding its extension of credit. This can often be a good thing, as this filters out customers who may be more likely to take a long time in paying their debts. On the other hand, a company’s policy may be too conservative if it is too tight in extending credit, which can drive away potential customers and give business to competitors. In this case, a company may want to loosen policies to improve business, even though it may reduce its receivables turnover ratio.
A low ratio, in a similar way, can also suggest a few things about a company, such as that the company may have poor collecting processes, a bad credit policy or none at all, or bad customers or customers with financial difficulty. Theoretically, a low ratio can also often mean that the company has a high amount of cash receivables for collection from its various debtors, should it improve its collection processes. Generally, however, a low ratio implies that the company should reassess its credit policies in order to ensure the timely collection of imparted credit that is not earning interest for the firm.
Uses of 'Receivables Turnover Ratio'
The receivables turnover ratio has several important functions other than simply assessing whether or not a company has issues collecting on credit. Though this offers important insight, it does not tell the whole story. For example, if one were to track a company’s receivables turnover ratio over time, it would say much more about the company’s history with issuing and collecting on credit than a single value can. By looking at the progression, one can determine if the company’s receivables turnover ratio is trending in a certain direction or if there are certain recurring patterns. What is more, by tracking this ratio over time alongside earnings, one may be able to determine whether a company’s credit practices are helping or hurting the company’s bottom line.
While this ratio is useful for tracking a company’s accounts receivable turnover history over time, it may also be used to compare the accounts receivable turnover of multiple companies. If two companies are in the same industry and one has a much lower receivables turnover ratio than the other, it may prove to be the safer investment.
Limitations of 'Receivables Turnover Ratio'
Like any metric attempting to gauge the efficiency of a business, the receivables turnover ratio comes with a set of limitations that are important for any investor to consider before using it.
One important thing to consider is that companies will sometimes use total sales instead of net sales when calculating their ratio, which generally inflates the turnover ratio. While this is not always necessarily meant to be deliberately misleading, one should generally try to ascertain how a company calculates their ratio before accepting it at face value, or otherwise should calculate the ratio independently.
Another important consideration is that accounts receivable can vary dramatically over the course of the year. This means that if one picks a start and end point for calculating the receivables turnover ratio arbitrarily, the ratio may not reflect the true climate of the company’s issuing of and collection on credit. As such, the beginning and ending values selected when calculating the average accounts receivable should be carefully picked so as to represent the year well. In order to account for this, one could take an average of accounts receivable from each month during a twelve-month period.
It is also important to note that comparisons of different companies’ receivables turnover ratios should only be made when the companies are in same industry, and ideally when they have similar business models and revenue numbers as well. Companies of different sizes may often have very different capital structures, which can greatly influence turnover calculations, and the same is often true of companies in different industries. The receivables turnover ratio is not particularly useful in comparing companies with significant differences in the proportion of sales that are credit, as determining the receivables turnover ratio of a company with a low proportion of credit sales does not indicate much about that company’s cash flow. Comparing such companies with those that have a high proportion of credit sales also does not usually indicate much of importance.
Lastly, a low receivables turnover ratio might not necessarily indicate that the company’s issuing of credit and collecting of debt is lacking. If, for example, distribution messes up and fails to get the right goods to customers, customers may not pay, which would also decrease the company’s receivables turnover ratio.