Understanding The Accounts Receivable Turnover Formula
An Accounts Receivable Turnover Formula allows a company to measure whether or not the company is effectively collecting payments for sales made on credit. A high turnover indicates higher cash basis sales or efficient collections.
A low turnover indicates collection problems and possibly bad debts. Most companies do not charge interest on Accounts Receivable unless the account becomes past due. An extension of credit is then essentially an interest free loan to their customers and not collecting payments on time creates inefficiency and opportunity costs for the company. For example, the company could use the cash to invest the money and earn interest, pay down debt from which the company is incurring interest expenses, or finance expansion instead of having its money tied up in Accounts Receivable. Sometimes late payments can cause financial hardship on a company; an example is their contractor payroll may depend on its customers paying on time.
So why do companies sell products on credit in the first place? Companies believe that by selling on credit they can achieve better sales and profits than they would if their sales were on a cash basis only. Even though a firm runs the risk of not being able to collect on some receivables, it hopes that the amount of additional sales made will surpass the number of Account Receivables not paid.
To encourage prompt payment, companies often offer sales discounting. For example, a company may offer "2%/10, net 30." This means if a customer purchases products and pays within 10 days, they can take 2% off the total price. Otherwise full payment is due within 30 days. This is equivalent to the customer earning 36% annually just for paying on time (.02 X 18, the number of 20 year periods in a year). Nonetheless, it is almost a given that a certain percentage of customers will not pay on time, and estimates of uncollectible accounts should be made when it can be reasonably estimated. This is where an Accounts Receivable Turnover Formula comes in. One such Accounts Receivable Turnover Formula is: Net Credit Sales/Average Net Receivables, where Net Average Receivables = (Beginning Net Receivables Balance + Ending Net Receivables Balance)/2 Alternatively, businesses may use a two step Accounts Receivable Turnover Formula: Average Sales Per Day = Credit Sales or Total Sales/365, Average Collection Period = Accounts Receivable/Average Sales Per Day Since many companies do not disclose total sales on credit, many companies use these Accounts Receivable Turnover Formula methods to determine Accounts Receivable Turnover. Make sure, when comparing turnover ratios, that the same sales type is used when calculating receivable turnovers.
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