Ratios: Accounts Receivable (AR) Turnover: Videos & Practice Problems

The accounts receivable turnover ratio measures how efficiently a company extends credit and collects payments from customers. It is calculated using the formula: AR(turnover)=NetCreditSalesAverageAccountsReceivable. A higher ratio indicates better efficiency, while an abnormally high ratio may suggest overly strict credit terms, potentially losing valuable customers. Understanding this ratio is crucial for effective financial management and benchmarking against industry standards.

Ratios: Accounts Receivable (AR) Turnover

The accounts receivable turnover ratio is a key efficiency metric that measures how effectively a company manages its credit sales and collects payments from customers. This ratio is calculated by dividing net credit sales by the average accounts receivable. Specifically, the formula is:

\[\text{Accounts Receivable Turnover Ratio} = \frac{\text{Net Credit Sales}}{\text{Average Accounts Receivable}}\]

To find the average accounts receivable, you take the sum of the beginning and ending balances of accounts receivable and divide by two:

\[\text{Average Accounts Receivable} = \frac{\text{Beginning AR} + \text{Ending AR}}{2}\]

In cases where only one accounts receivable figure is provided, that figure should be used directly as the average. The accounts receivable turnover ratio indicates how many dollars of sales are generated for each dollar of credit extended. A higher ratio suggests that the company is efficient in collecting its receivables, meaning it can convert credit sales into cash quickly.

When analyzing the accounts receivable turnover ratio, it is essential to benchmark against industry standards. Different industries have varying norms for credit sales; thus, a high turnover ratio is generally favorable, indicating effective credit management. However, an excessively high ratio may signal overly strict credit terms, potentially alienating customers who require more flexible payment options.

For example, if a company has net sales of $500,000 and an average accounts receivable of $50,000, the accounts receivable turnover ratio would be:

\[\text{AR Turnover Ratio} = \frac{500,000}{50,000} = 10\]

This result means that for every dollar of credit extended, the company generates $10 in sales, reflecting strong credit management practices. Understanding and calculating this ratio is crucial for businesses to optimize their credit policies and improve cash flow.

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

Answer: (C)

Here’s what students ask on this topic:

What is the formula for calculating the accounts receivable turnover ratio?

The formula for calculating the accounts receivable turnover ratio is:

NetCreditSalesAverageAccountsReceivable

This ratio measures how efficiently a company extends credit and collects payments from its customers. A higher ratio indicates better efficiency in managing receivables.

How do you calculate the average accounts receivable balance?

To calculate the average accounts receivable balance, use the following formula:

BeginningAR+EndingAR2

Where Beginning AR is the accounts receivable balance at the start of the period, and Ending AR is the balance at the end of the period. This average is used in the denominator of the accounts receivable turnover ratio formula.

Why is a higher accounts receivable turnover ratio generally considered better?

A higher accounts receivable turnover ratio is generally considered better because it indicates that a company is efficient in extending credit and collecting payments from its customers. This means the company can quickly convert its receivables into cash, improving liquidity and reducing the risk of bad debts. However, an abnormally high ratio might suggest overly strict credit terms, potentially losing valuable customers who need more flexible payment options.

What does an abnormally high accounts receivable turnover ratio indicate?

An abnormally high accounts receivable turnover ratio may indicate that a company's credit terms are too strict. While a high ratio generally suggests efficient credit management, overly stringent credit terms can deter potential customers who require more flexible payment options. This could result in lost sales and missed opportunities to build long-term customer relationships. Therefore, it's essential to balance credit policies to maintain both efficiency and customer satisfaction.

How can benchmarking be used to evaluate the accounts receivable turnover ratio?

Benchmarking involves comparing a company's accounts receivable turnover ratio to industry standards or competitors. This helps determine whether the company's credit and collection practices are efficient relative to others in the same industry. By understanding industry norms, a company can identify areas for improvement and set realistic targets for its credit management policies. Benchmarking provides valuable insights into how well a company is performing in managing its receivables compared to its peers.