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14. Financial Statement Analysis

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Ratios: Accounts Receivable (AR) Turnover

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So let's discuss a ratio here real quick. The accounts receivable turnover ratio. So the accounts receivable turnover ratio. Well this is gonna relate the amount of sales, right the net sales. And I want to be actually a little more specific because we usually deal with credit sales here net credit sales to our average accounts receivable level. Okay so the accounts receivable turnover ratio. It's a common efficiency ratio that we use. Okay, this is seeing how efficiently we extend credit to our customers. How long it takes to pay us. That kind of information is what we can pull out of the accounts receivable turnover. So let's go right in and let's calculate our accounts receivable turnover notice In our in our numerator we have net credit sales, net credit sales and I have the credit in parentheses there because sometimes a problem might not mention credit sales. They'll just tell you net sales or just sales revenue. And if that's all you got, well that's what you're gonna have to use in the problem. But when we're being really specific we want to talk about credit sales right? Remember that accounts receivable. That's when we sell something to a customer and we say, hey you can pay us later. So it's a credit sale. We sell it to them on credit. But with the lack of better information we'll just use our sales revenue. So our numerator, we've got those net credit sales and in our denominator we've got our average accounts receivable balance. So anytime we're gonna calculate an average balance in an account, the average balance is always going to be calculated as the beginning balance in the account. And I'm gonna put this in parentheses plus the ending balance in the account divided by two. Right? We're always that's how we calculate the average balance in an account beginning plus ending divided by two. And that's exactly what we have here. Right notice here in the second equality beginning A. R. Plus ending A. Are divided by two. So that's all happening in the denominator. Usually when I calculate this I like to calculate that first separately and get my average balance before I go ahead and calculate my A. R. Turnover and one more note about that. Right? What if they don't give you two numbers? If they don't give you a beginning balance and ending balance they just give you one number. Well that's it you just use that number. There's no average balance to calculate. You. Just use the number that they give you. They say one number for a are that's what you'll use. Cool. So how do we analyze the er turnover ratio? What does it mean when we calculate it? So it's gonna tell us how many sales dollars we get for each dollar of credit we extend. Right notice the remember whenever we calculate a ratio it's how much of how much of the numerator for each one of the denominator. So for each dollar of credit we extend, how many times can we get a credit sale out of it. Okay. And remember that this average A. R. Well we're gonna be extending credit so there's customers that we're gonna say okay you can pay us later but there's other customers that we extended credit to previously that are gonna be paying us. So it's kind of a constant flow. We're extending credit, we're getting money from customers that owed us. It's just gonna be flowing like that. So we're gonna have some average balance there. So for that average amount that's outstanding, how many times can we turn that into some credit sales? Cool. Alright. So how do we compare, how do we compare our A. R. Turnover ratio? How do we know if it's a good one or a bad one? Well like a lot of ratios we're gonna use benchmarking. We want to understand our industry, there's some industries that credit extending credit to the customers is crucial to the business where there's other industries where you can always just rely on cash transactions. Alright. So it depends on the industry and you're gonna want to compare to your competitors to the industry? Average things like that. All right. So what do you think with with an A. R. Turnover? Do we want a high turnover ratio or a low turnover ratio? It's generally going to be better to have a high turnover ratio. That means you can keep a low balance of credit and be able to extend it and be able to make a lot of sales out of small amounts of credit. Okay, so in general, I want to say in general, higher turnover ratios mean that you're being very efficient with extending credit to your customers. Okay. But I have this red flag down here. If you have an abnormally high, if you have an abnormally high A. R. Turnover. Well this could signal something that your credit terms are too tight. Ok. This means that you're getting a lot of sales but you're not offering too much credit to your customers. And this could maybe lose you some good potential customers. Right? There could be good customers that need credit terms to for it to be a beneficial trade for them. Maybe you're reselling business and you sell to other wholesalers and they want some time to be able to see sell their product. But if you're too tight with your credit terms, well they might go somewhere else instead of buying from you. Okay. So that could be something you look for. If maybe you're doing an analysis project, maybe you could see something where you have a really high a our turnover. This could be a nice little paragraph to talk about that and get some extra points. Alright. But in general when you deal with this, we're just gonna be doing calculations and calculating a our turn over. So why don't we start here and we'll do an example together and then you guys can practice on your own. Cool let's try this one X. Y. Z. Company had net sales of 500,000 and cogs of 320,000. If the beginning balance of A. R. Was 75,000 and the ending balance of A. R. Was 45,000. What is the A. R. Turnover ratio? So notice they gave us some information that sales. But they also talked about cogs. Cogs is an important number when we're doing our inventory turnover ratios. Okay so this is a different case. We're talking about a our turnover ratios in this case and a our turnover. What we deal with sales in this example right? Net sales is the important number and cogs is not important. We're not gonna use that at all. Look at our ratio above right. The ratio doesn't mention cogs. It doesn't mention gross profit. Anything that we'd have to use cogs to to calculate that. And again noticing this problem that they just say net sales they don't say net credit sales they don't talk about credit terms or anything like that. So we just have to take it at face value and say that the net sales is going to be our numerator. So our denominator is that average a our balance and we've got a beginning balance and an ending balance. So we know that we can calculate an average with the beginning and ending balance. And I always like to start with that. So average a. R. That's gonna be the beginning balance of 75,000 Plus the ending balance of 25,000. And then we're gonna divide all of that by two. So remember you want to add those 1st 75,000 plus 25,000? Well that's 100,000 divided by two. Our average a. r. is 50,000. Right. On average the balance is 50,000. So let's go ahead and finish this up by calculating the er turnover. And remember our numerator is net sales. So the net sales were 500,000. And if they had given us net sales for cash and net sales for credit sales well we would use those credit sale numbers but we're using 500,000 here. And we divide by that average A. R. That we calculated of 550,000 divided by 50,000. Well that comes out to 10 right? 10 is our A. R. Turnover ratio. And that's gonna be our answer here. So remember what does that mean? That means for every dollar of credit we extend we're able to turn it into $10 of sales. Cool let's go ahead and move on. And you guys try the practice problem coming up

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Problem

ABC Company had $200,000 in Net Sales and Gross Profit of $80,000. If AR had a balance of $16,000, what is the AR Turnover ratio?

A

5

B

7.5

C

12.5

D

Not enough information

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