Accounts receivable (AR) represents money owed to a company by its customers who have received goods or had services performed and have not yet paid for them. In other words, outstanding invoices.
Receivables, as they are commonly known, are typically due in 30 or 60 days, or less than a year. Receivables are considered a liquid asset since they can be sold for cash (at a discount) or used as collateral to help meet short-term obligations.
Accounts Receivable: Current Asset
Many companies operate by extending customers a line of credit based on defined payment terms. Think of a utility company that bills for electricity or water after it has been provided to the customer or a doctor that bills for medical services after they have been performed. Because the customer has a legal obligation to pay outstanding invoices in a short period of time, accounts receivable are a current asset on a company's balance sheet.
Current assets are assets that can reasonably be expected to be converted into cash within one year or less. A company's accounts receivable balance is a measure of additional cash that a company will have available to meet its short-term obligations without additional cash flow. What that means is accounts receivable are one measure of a company's liquidity.
When it becomes evident that certain receivables will not ever be paid, they are written off as a bad debt expense, so they don't remain in the accounts receivable balance.
What is Accounts Receivable Turnover?
The accounts receivable turnover ratio is an important financial ratio that measures how quickly and efficiently a company collects its receivables. This ratio measures how many times a business collects its average receivables, which in turn is a measure of financial stability, efficient cash flow management, and the ability to meet its own obligations as they become due.
A higher turnover rate indicates a solid credit policy, a well-managed collections process, and high-quality customers who typically pay in full and on time. By contrast, a low turnover ratio indicates poor credit policy, inefficient collections processes, and customers who pay late – or may not even pay at all.
Like any such generalizations, there are exceptions here as well. Sometimes, a tighter credit policy, although ensuring efficient collections and a strong cash flow, can keep away potential customers. During times of economic hardship or facing tough competition, a company may be willing to tolerate a lower ratio to increase sales.
When analyzing accounts receivable turnover, it is important to compare ratios of companies within the same industry to ensure that the ratio of a business is on par for its specific industry.
Calculating Accounts Receivable Turnover Ratio
To calculate a company's accounts receivable turnover, use the following formula:
Accounts Receivable Turnover=Net Credit Sales divided by Average Accounts Receivable
Average accounts receivable is determined by taking the beginning and ending balances of accounts receivable for the specified time period.
Let's look at an example to see how this ratio works.
An investor wants to purchase Sweet Things, a commercial bakery that delivers platters and customized baked goods to businesses and restaurants. Most of their sales are made on credit with 30-day payment terms. Business for Sweet Things is fairly steady throughout the year, and the potential buyer wants to compare its accounts receivable turnover with that of other similar businesses.
Sweet Things Bake Shop
December 31, 2020
Net Credit Sales
Accounts Receivable, Jan 1
Accounts Receivable, Dec 31
Accounts Receivable Turnover Ratio
To arrive at the accounts receivable turnover ratio, we first compute the average accounts receivable for the year. We add the beginning and ending balances for accounts receivable, for a total of $50,000. Divide this figure by two for an average accounts receivable of $25,000.
Next, take net credit sales of $200,000 and divide them by the average receivables of $25,000. This yields a turnover ratio of 8, which means that the company is turning over, or collecting, its accounts receivable eight times a year.
As part of working capital, accounts receivable is one key way to measure a company's liquidity and short term-health. But even more than that, accounts receivable turnover also measures the quality of a company's customer base and its ability to continue to do healthy business in the future.