One of the activity ratios<\/span><\/strong><\/a> in business is the receivables turnover ratio or rate. This ratio measures the frequency of collecting the entire balance of accounts receivable<\/span><\/strong><\/a> during a standard accounting year. The ideal turns rate is twelve with a higher value indicating an aggressive collection process. A lower value is a warning about accounts receivable management.<\/span><\/p>\n For the reader to fully understand the accounts receivable turnover ratio<\/strong> you must first learn how to calculate the turnover rate. Once there is an understanding of the formula; proper application is necessary to appreciate the value this turnover ratio can generate. Finally, this article will provide insight into evaluating the ratio when reading financial reports.<\/span><\/p>\n The promulgated formula for receivables turnover rate is total sales divided by the average accounts receivable balance. As an example, it total sales were $1.6 Million and the average receivables balance was $140,000, then the turnover rate is 11.43. This formula works perfectly with a 100% pure invoicing operation like professional firms or manufacturers. However, the bulk of economic activity at the small business level is exit pay (payment at time of service\/sale) and therefore a mix of both cash sales and sales on account exist. A good example is a marina. Assume their sales are $1.6 Million and half those sales are on account. The average receivables is $70,000 per month. Now the receivables turnover rate is 22.86. Here is the formula:<\/span><\/p>\n Receivables Turnover Ratio = \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0<\/span>Total Sales \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0<\/span><\/span> Now let’s look at the formula adjusted for sales that are invoice (on account) based and calculate the result.<\/span><\/p>\n Receivables Turnover Ratio =\u00a0\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0\u00a0<\/span>Total Sales on Account Therefore a more accurate receivables turnover ratio should exclude sales paid with cash, check, credit or debit card. The only value in the numerator are sales directly made on account.<\/span><\/p>\n As for the denominator, the formula is more accurate and consistent if aged receivables are written off in accordance with a sound financial policy. Good operations will transfer receivables aged 150 or more days to either an aged receivables account or straight to uncollectible via bad debt expense. If using aged receivables account, the invoices are discounted to a realistic collectible value. If aged receivables are not removed from the receivables balance, the balance will disproportionately lean towards greater stability (weighted average of uncollectible accounts increases over time) distorting the receivables turnover rate.<\/span><\/p>\n An illustration is appropriate.<\/span><\/p>\n Assume the marina has $800,000 per year in accounts receivable sales. Invariable, 2% of all invoices are never paid nor written off. All other invoices are collected within the normal 30 day cycle. Let’s take a look at the continuous A\/R (Accounts Receivable) balance increase and the effect on the ratio.<\/span><\/p>\n \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 A \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0B \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0C \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0D<\/span> Ideally, an excellent indicator of accounts receivable turnover is a consistent value from one time period to the next. If there were no collection issues the turnover rate for the year would be 11.43, with this continuous increase of uncollectible accounts the turnover rate has dropped to 10.29, a full turn less.<\/span><\/p>\n There are some basic rules in using this activity ratio. The first is proper application of the rate.<\/span><\/p>\n The key to this ratio is realizing that it measures the ability to collect the receivables in a timely manner. The derived rate is either compared to the historical trend or compared against a standard. If the resulting value decreases from the average or standard it is a clear sign that either there are collection issues or <\/span>the overall accounts receivable age is increasing.<\/span><\/span><\/p>\n Here is an illustration:<\/span><\/p>\n Mattress Manufacturing<\/u><\/span><\/strong><\/span><\/p>\n In a year, mattress manufacturing sells $3.4 Million in mattresses, all on account. Sales are stable throughout the year. The average age of invoices is 22 days. Therefore the average accounts receivable balance is $207,778 ($283,333\/month in sales * 22\/30). The average turnover rate is 1.36 per month; which is very high (good). This equates to 16.36 per year. The accounts receivable manager goes on a three-month maternity leave. During this period the average age of accounts receivable increases to 28 days. What is the resulting turnover rate?<\/span><\/p>\n 28 day average equates to $264,444 ($283,333 * 28\/30) in accounts receivable. The turnover rate decreases (poorer) to 1.07 from 1.36 or annualized as 12.86 down from 16.36.<\/span><\/p>\n With the circumstance illustrated above, this is an aging issue. Let’s modify the above and change the conditions. Same company, same sales and accounts receivable manager with an average age receivables of 22 days. One of the customers is a three store retailer that purchases $50,000 per month of mattresses. Always pays his bill within two weeks making him an excellent customer. He suddenly dies and he left no will or gave signatory rights to anyone else in his company. His case is tied up in a legal quagmire. His company’s account goes unpaid; worse yet, there are no orders. Let’s see the results of the turnover rate. The customer dies on the first day of month number 2.<\/span><\/p>\n Month<\/u>\u00a0 \u00a0\u00a0Sales<\/u>\u00a0 \u00a0 \u00a0 \u00a0Average A\/R Balance<\/u>\u00a0 A\/R Turnover Rate This customer’s death immediately distorts the turnover rate and will continue to distort without some form of rectification of the uncollectible balance. In this case the company does have a policy that transfers out of receivables into a legal claim account any receivable older than 90 days.\u00a0\u00a0 So in month four, the $50,000 balance is removed from the accounts receivable into a legal claims account.\u00a0\u00a0 Now look at the turnover rate.<\/span><\/p>\n Month<\/u>\u00a0 \u00a0 Sales<\/u>\u00a0 \u00a0 Average A\/R Balance<\/u>\u00a0 \u00a0\u00a0A\/R Turnover Rate<\/u>Accounts Receivable Turnover Ratio Formula<\/span><\/strong><\/h2>\n
\n\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 Average Accounts Receivables Balance<\/span>
\n Receivables Turnover Ratio – \u00a0 \u00a0$1,600,000<\/u>\u00a0 = \u00a022.86<\/span>
\n\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0$70, 000<\/span><\/p>\n
\n<\/span>\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 Average Accounts Receivable Balance<\/span>
\n Receivables Turnover Ratio \u00a0\u00a0\u00a0\u00a0 = \u00a0 \u00a0$800,00<\/u>0\u00a0(<\/span>1\/2 of All Sales)
\n<\/u>\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0$70,000 Average A\/R Balance<\/span>
\n Receivables Turnover Ratio\u00a0\u00a0\u00a0\u00a0\u00a0 = \u00a0 \u00a011.43<\/span><\/p>\n
\n\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0A\/R \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0A\/R \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 Ending<\/span>
\n\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 Sales \u00a0 \u00a0 \u00a0Beginning \u00a0 \u00a0Collection \u00a0 \u00a0 \u00a0A\/R Balance \u00a0 \u00a0 \u00a0 Ratio<\/span>
\n Month<\/u>\u00a0\u00a0On Acct<\/u>\u00a0 \u00a0\u00a0Balance<\/u>\u00a0 \u00a0 @ 987<\/u>\u00a0<\/span>(A*.98)<\/u>\u00a0\u00a0 (A+B-C)<\/u>\u00a0 \u00a0 \u00a0A\/((B+D)\/2)<\/span><\/span>
\n\u00a0 Jan \u00a0 \u00a0$66,667\u00a0 \u00a0 \u00a0$70,000 \u00a0 \u00a0 \u00a0 \u00a0 $65,334 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0$71,333 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0.943<\/span>
\n\u00a0 Feb \u00a0 \u00a0 66,667 \u00a0 \u00a0 \u00a0 71,333\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a065,334 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a072,666 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0.926<\/span>
\n\u00a0 Mar \u00a0 \u00a0 66,667 \u00a0 \u00a0 \u00a072,666\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a065,334 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a073,999 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0.909<\/span>
\n\u00a0 Apr\u00a0 \u00a0 \u00a066,667 \u00a0 \u00a0 \u00a073,999\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a065,334 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a075,332\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0.893<\/span>
\n\u00a0 May\u00a0 \u00a0 66,667 \u00a0 \u00a0 \u00a075,332\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a065,334 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a076,665 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0.877<\/span>
\n\u00a0 Jun\u00a0 \u00a0 \u00a0 66,667 \u00a0 \u00a0 \u00a076,665\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a065,334 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a077,998 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0.862<\/span>
\n\u00a0 Jul\u00a0 \u00a0 \u00a0 \u00a066,667 \u00a0 \u00a0 \u00a077,998\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a065,334 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a079,331 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0.847<\/span>
\n\u00a0 Aug\u00a0 \u00a0 \u00a066,667 \u00a0 \u00a0 \u00a079,331\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a065,334 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a080,664 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0.833<\/span>
\n\u00a0 Sep\u00a0 \u00a0 \u00a0 66,667 \u00a0 \u00a0 \u00a080,664\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a065,334 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a081,997 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0.820<\/span>
\n\u00a0 Oct\u00a0 \u00a0 \u00a0 66,667 \u00a0 \u00a0 \u00a081,997\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a065,334 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a083,330 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0.806<\/span>
\n\u00a0 Nov\u00a0 \u00a0 \u00a066,667 \u00a0 \u00a0 \u00a083,330\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a065,334 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a084,663 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0.794<\/span>
\n\u00a0 Dec\u00a0 \u00a0 \u00a066,667<\/u>\u00a0 \u00a0 \u00a0 84,663\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a065,334\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 85,996 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 .781
\n<\/u>\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 $800,000\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 10.29<\/span><\/p>\nProper Application of the Accounts Receivable Turnover Rate<\/span><\/strong><\/h2>\n
\n<\/u>\u00a0 1 \u00a0 \u00a0 \u00a0 $283,333 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 $207,778 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 1.36<\/span>
\n\u00a0 2 \u00a0 \u00a0 \u00a0 \u00a0 233,333 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 214,444 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 1.09<\/span>
\n\u00a0 3 \u00a0 \u00a0 \u00a0 \u00a0 233,333 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 221,110 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 1.06<\/span><\/p>\n
\n<\/u>\u00a0 1 \u00a0 \u00a0 \u00a0$283,333 \u00a0 \u00a0 \u00a0 \u00a0 $207,778 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a01.36<\/span>
\n\u00a0 2 \u00a0 \u00a0 \u00a0 \u00a0233,333 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 214,444 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a01.09<\/span>
\n\u00a0 3 \u00a0 \u00a0 \u00a0 \u00a0233,333 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 221,110 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a01.06<\/span>
\n\u00a0 4 \u00a0 \u00a0 \u00a0 \u00a0233,333 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 196,110 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a01.19<\/span>
\n\u00a0 5 \u00a0 \u00a0 \u00a0 \u00a0233,333 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 171,110 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a01.36<\/span><\/p>\n
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