The receivables turnover ratio is a financial analysis tool used to measure a company’s ability to collect outstanding account receivables balances. This ratio determines how quickly a company collects outstanding cash balances from its customers during an accounting period. A high calculated figure from the receivables turnover ratio indicates the company operates mostly through cash sales to customers. A high figure may also indicate how the company has a strong business policy for collecting outstanding customer balances.
Businesses often sell goods or services to consumers on account. Outstanding balances are held in the company’s accounts receivable journal. While high account receivable balances can be seen as a good thing, companies who fail to collect outstanding balances in a timely manner may run into cash flow issues. Additionally, continually offering account sales to customers who have previous unpaid balances can also create difficult cash flow situations. The receivables turnover ratio is a way the business owner or manager can review receivables balance in a timely manner. This financial ratio is commonly reviewed each month or on an annual basis to determine the effectiveness of the company’s cash collections during an accounting period.
The classic receivables turnover ratio formula is net credit sales divided by average net accounts receivable. Net credit sales is the amount of sales revenues less discounts, returns or other allowances posted in the company’s accounts receivable journal. Average net accounts receivable is the company’s total outstanding accounts receivable less the allowance for bad debts expense. Bad debts expense is the percentage of outstanding receivables the company estimates it cannot collect and will eventually write off. Bad debts expense often occurs when companies extend credit to customers with poor credit history or the inability to repay large outstanding receivables balances.
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As an example, if a company has $5,525,000 United States Dollars (USD) in net sales at the end of the year and $500,000 USD in net accounts receivable, the company would have a receivables turnover ratio of 9.5. This number indicates the company has collected its open accounts receivable balance nine and a half times during the calendar year.
Companies often compare the ratio calculation to a competing company or the industry standard. This comparison can help business owners or managers understand how well their company stacks up to other companies' receivables turnover ratio. Business owners and managers may also need to improve the company’s collection procedures to improve this number. It is important to note that this number simply represents an average calculation for assessing accounts receivable turnover. Using average figures in business or financial ratios can distort the company’s actual operational performance.