Definition: The number of times each year that customers are billed by a company, pay those bills, and then are billed again. The formula: Sales / Ending Accounts Receivable.
Example: Super Sales Co. achieves Sales of $1,200,000 this year. At the end of the year, its Accounts Receivable balance is $100,000. This results in a turnover of $1,200,000 / $100,000, or 12. How can Sales be so high for the year when customers, as of the end of the year, owe just a fraction of this amount? All throughout the year, customers have been purchasing from Super Sales, getting billed, and paying those bills. By dividing the amount of Sales by the amount that customers owe (ie, Accounts Receivable) at any one time, we get a reasonably precise measurement of how many times per year the cycle occurs. In our example, it takes place 12 times per year, or once per month.
Investeach explains: The higher this ratio, the better. A higher ratio means that companies are billing and collecting from their customers more quickly and repeating the cycle more times per year. This also means that the amount that customers owe the company at any time is lower.
This ratio makes several assumptions that you should be aware of. One is that all Sales are made “on account” (ie: none are paid with cash at the time of sale) meaning that they all pass through the Accounts Receivable account. What would happen if a company was paid in cash for some of its sales? Let’s consider the above company. If $200,000 of its sales were paid in cash, then the amount of sales going through Accounts Receivable account would be reduced to $1,000,000. This means that the true turnover ratio is $1,000,000 / $100,000, or 10!
A second point is that the Accounts Receivable account balance at the end of the year is just a snapshot at that time. It may or may not represent the average amount owed over the course of the year. To be more accurate, you could average the Accounts Receivable balance at several points during the year, such as the balance at the end of each month.
Riddle me this:
1. What is the Accounts Receivable Turnover Ratio designed to measure?
2. Explain why a higher ratio is better.
3. What is a key assumption made about the company’s sales for this ratio to be accurate?