Sales on credit basis are one of the important aspects of entity and can significantly impact entity’s revenue. In credit transactions the credit period, credit terms and recovery of such credit plays an important role. Allowing credit to customers help increase sales revenue. However if it is not managed correctly then entity may end up with liquidity problems. Therefore, understanding how this activity is managed is important and is usually measured in terms of Receivable turnover ratio.
Receivable turnover ratio measures how efficiently entity has collected money from its debtors after credit sale is made to them in a given period. So basically it is measuring the time between two instances i.e. the time credit sales is made and the time when payment is received against credit sales.
Therefore, higher the frequency (higher the ratio) shorter the recovery period. In other words higher turnover ratio translates into shorter elapsed time between sales and cash inflow.
Receivable turnover ratio is calculated using the following formula:
Revenue / Average receivables
Credit sales / Average receivables
For accurate measurement total of credit sales is preferred over total revenue figure. The fact is that receivables are not arisen as a result of cash sales therefore, only credit sales figure should be considered. However, revenue is usually reported on totality basis without sub-classification of credit sales and cash sales and therefore total revenue can be used for analysis purposes.
Few points to remember:
Revenue or Sales figure must be net of sales returns figure. As receivables figure will also be adjusted for any sales returns in individual accounts of debtors
Average receivables are calculated usually as follows:
|Average receivables =||Receivables at the beginning of the year + Receivables at the end of the year|
PakAccountants Inc. has reported a revenue of 2 million for the last year. 85% of sales were credit based. Receivables at the start of the year were 200,000 and the year end balance was 300,000.
Receivables turnover = Credit sales / Average receivables
Credit sales = 2,000,000 x 0.85 = 1,700,000
Average receivables = (200,000 + 300,000) / 2 => 250,000
Receivable turnover = 1,700,000 / 250,000 = 6.8
Analysis and Interpretation
To better understand PakAccountants Inc. receivables turnover situation we need to have a comparative information like previous year’s data or receivables turnover figures of another entity in the same industry.
Suppose last year’s turnover ratio was 6, then it seems turnover ratio has improved and indicative of improved efficiency in collecting cash from debtors.
Suppose further that industry average turnover ratio is 4. Comparing industrial information with entity’s ratio suggests that entity’s debt collection is pretty fast.
Though high receivables turnover is what every entity desires but it may also indicate that entity’s debt collection policy is too strict and probably the situation is even worse as stricter collection policies may translate into customer’s dissatisfaction and resulting in lost sales especially if competitors are offering longer credit period on relatively flexible terms. Therefore, while observing turnover ratio, analysts must also observe revenue trends i.e. if increased turnover ratio is met with decreased sales then it may confirm that entity has going too strict and its revenue may improve if it relaxes the credit terms a little.
Low turnover ratio is generally indicative of management’s inefficiency in collecting debt from customers on time and thus pushing entity to rely on shot term loans to fulfill cash needs which will also burden entity’s profit due to increase finance cost. However, in certain cases sacrificing on turnover ratio may help improve revenue so managers and analysts must consider the bigger picture beyond this ratio alone to better understand the situation.
Concluding the discussion we understood that receivable turnover ratio surely help us make better analysis of entity’s performance however it is not always a definitive way to measure. A better approach would be to make aged receivables analysis to know if entity is really struggling with debt collection.