What is a Receivables Turnover Ratio?
The receivables turnover ratio is a company's sales made on credit as a percentage of average accounts receivable. The formula for receivables turnover ratio is:
Receivables Turnover = Net Credit Sales/Average Accounts Receivable
How Does a Receivables Turnover Ratio Work?
For example, let's assume that Company XYZ sells $10,000,000 of widget parts this year. Of those sales, $8,000,000 were on credit, meaning that those customers did not pay immediately for the widgets they bought. Company XYZ usually carries an average of $400,000 in accounts receivable on its balance sheet. Receivables are assets, and as such, they appear on the balance sheet. In particular, receivables are current assets, meaning the amount owed is expected to be received within the next 12 months.
Using this information and the formula above, we can calculate that Company XYZ's receivables turnover ratio is:
Receivables Turnover Ratio = $8,000,000/$400,000 = 20
By dividing 365 days by the ratio, we find that Company XYZ takes about 18 days to turn over its accounts receivable.
Why Does a Receivables Turnover Ratio Matter?
Receivables turnover is a measure of how well a company collects money from customers. If it's too low, the company may be lax in collecting what's owed too it and may soon be struggling to find the cash to pay the bills; if too high, the company may be unwisely harming customer relationships or not offering competitive payment terms. In general, receivables levels correspond to changes in sales levels.
It is important to note that different industries have different norms and standards regarding receivables collection, and so determining whether a turnover ratio is high or low should be made within this context. It is also important to note that because the formula uses average, it is possible that one or two customers could artificially drive the numbers up or down.