Accounts Receivable Turnover Ratio

The accounts receivable activity ratios indicate the speed with which the company collects its receivables.

The accounts receivable turnover ratio is used to measure the number of times receivables “turn over” during a year’s time, or are collected and are replaced with new receivables. It tracks the efficiency of a firm’s accounts receivable collections and indicates the amount of investment in receivables that is needed to maintain the firm’s level of sales. Comparing a company’s accounts receivable turnover ratio from one year to the next enables analysis of how the company’s collection rate has changed over time. An increase in the accounts receivable turnover ratio indicates that receivables are being collected more rapidly. A decrease indicates slower collections.

“Net annual credit sales” means gross sales net of the allowance for returns and allowances, not sales net of the allowance for credit losses. Note that the numerator of this ratio represents a full year’s net credit sales.

If the period being analyzed is for less than one year, the credit sales should be annualized (for example, one quarter’s credit sales should be multiplied by 4, and so forth). The accounts receivable amount in the denominator should be the average gross trade accounts receivable for the same period as is represented by the numerator (even if it is for less than one year). Receivables for financing and investing activities are not included.

For example, if the credit sales figure is for one quarter, multiply it by 4 to annualize it. The average gross trade accounts receivable figure used in the denominator should be the average for just the one quarter represented by the net sales, not the average for a whole year.

If average gross accounts receivable is available, it should be used in preference to average net accounts receivable. The difference between gross receivables and net receivables is the allowance for credit losses. Accounts of customers who will not pay are included in the gross receivables figure, and sales made to customers who will not pay are included in the net annual credit sales figure. (As stated in the previous paragraph, “net annual credit sales” means sales net of the allowance for returns and allowances, not net of the allowance for credit losses.) Therefore, the use of gross receivables in the denominator of the ratio is consistent with the use of net annual credit sales in the numerator.

The credit sales figure in the numerator and the average gross receivables figure in the denominator should include only trade receivables. Receivables from financing and investment activities should be excluded unless customer financing is provided as a normal part of the company’s sales and the financed sales are included in the numerator.

If net total sales (including cash sales) is used as the numerator instead of net credit sales, the ratio will not provide accurate information on turnover of receivables. However, if the company’s cash sales are not material or not available, net total sales can be used as long as it is used consistently.

A company should extend credit until the marginal benefit (profit) of giving credit is zero. The point at which the marginal benefit is zero is the point at which the cost of extending additional credit and the benefit of extending additional credit are equal. The calculation of this point should take into consideration the opportunity costs of other investment options available to the company. In economics terms, the marginal cost of a credit and collection policy should not exceed the marginal revenue (actually, the marginal increase in the contribution margin) that it generates.