Receivables Turnover Ratio Defined: Formula, Importance, Examples, Limitations

In this example, a company can better understand whether the processing of its credit sales are in line with competitors or whether they are lagging behind its competition. The accounts receivables turnover ratio measures the number of times a company collects its average accounts receivable balance. It is a quantification of a company’s effectiveness in collecting outstanding balances from clients and managing its line of credit process. From the account receivable collection period of XYZ Co., it can be determined that the business has done exceptionally well when it comes to managing its account receivable balances. Not only have XYZ Co. managed to recover its balances within the 30 days credit period limit but also managed to do it 9 days (30 days – 21 days) before.

In order to calculate the average collection period, divide the average balance of accounts receivable by the total net credit sales for the period. Then multiply the quotient by the total number of days during that specific period. The average collection period amount of time that passes before a company collects its accounts receivable (AR). In other words, it refers to the time it takes, on average, for the company to receive payments it is owed from clients or customers. The average collection period must be monitored to ensure a company has enough cash available to take care of its near-term financial responsibilities.

Companies in these situations risk losing potential clients to rivals with superior lending standards. The Average Collection Period represents the number of days that a company needs to collect cash payments from customers that paid on credit. Make sure the same period is being used for both net credit sales and average receivables by pulling the numbers from the same balance sheets. Identifying these issues and resolving them can lower the number of days in your company’s average collection period, and will display how effectively your accounts receivable department is performing. Knowing the accounts receivable collection period helps businesses make more accurate projections of when money will be received.

The company wants to assess the account receivable outstanding at the end of December 2016. Log all payments and communication with customers so you can easily track and follow up if necessary. Ensure that their information is up-to-date and accurate, with all the payment data that the customer needs to make a prompt payment. It’s not enough to look at a final balance sheet and guess which areas need improvement. You must monitor and evaluate important A/R key performance metrics in order to improve performance and efficiency. The secret to accounts receivable management is knowing how to track and measure performance.

  1. Companies need to know their receivables turnover since it is directly tied to how much cash they have available to pay their short-term liabilities.
  2. Average collection period is calculated by dividing a company’s average accounts receivable balance by its net credit sales for a specific period, then multiplying the quotient by 365 days.
  3. Companies use the average collection period to make sure they have enough cash on hand to meet their financial obligations.

Another limitation is that accounts receivable varies dramatically throughout the year. These entities likely have periods with high receivables along with a low turnover ratio and periods when the receivables are fewer and can be more easily managed and collected. It measures the value of a company’s sales or revenues relative to the value of its assets and indicates how efficiently a company uses its assets to generate revenue. A low asset turnover ratio indicates that the company is using its assets inefficiently to generate sales. A high ratio can also suggest that a company is conservative when it comes to extending credit to its customers.

Average Collection Period

In today’s business landscape, it’s common for most organizations to offer credit to their customers. Similarly, a steady cash flow is crucial in construction companies and real estate agencies, so they can timely pay their labor and salespeople working on hourly and daily wages. Also, construction of buildings and real estate sales take time and can be subject to delays. So, in this line of work, it’s best to bill customers at suitable intervals while keeping an eye on average sales.

What is the Accounts Receivable Turnover Ratio?

This industry will emphasize shorter collection periods because real estate frequently requires ongoing financial flow to support its operations. These issues have pushed businesses to further streamline their accounts receivable process by implementing several key metrics and procedures to maintain liquidity. The goal for most companies is to find the right balance in their credit policy. This should be fair and accommodating to customers while efficient and realistic to the firm.

For example, an average collection period of 25 days isn’t as concerning if invoices are issued with a net 30 due date. However, an ongoing evaluation of the outstanding collection period directly affects the organization’s cash flows. It currently has an average account receivable of $250,000 and net credit sales of $600,000 over 365 days.

So Light Up Electric should compare its AR Turnover Ratio to the industry average to see how they’re doing. Even though a lower average collection period indicates faster payment collections, it isn’t always favorable. If customers feel that your credit terms are a bit too restrictive for their needs, it may impact your sales.

What is Account Receivable Collection Period?

For example, ABC wants to open up a new plant to expand its business operations, including expenses such as market research, licensing, labor costs, and other overhead costs. Over 1.8 million professionals use CFI to learn accounting, financial analysis, modeling and more. Start with a free account to explore 20+ always-free courses and hundreds of finance templates and cheat sheets.

Is It Better to Have a Low or High Collection Period?

If the accounts receivable collection period is more extended than expected, this could indicate that customers don’t pay on time. It’s a good idea to review your balance sheet and credit terms to improve accounts receivable collection period formula collection efforts. The average collection period is an accounting metric used to represent the average number of days between a credit sale date and the date when the purchaser remits payment.

Compare Your Performance to Industry Averages

Get instant access to lessons taught by experienced private equity pros and bulge bracket investment bankers including financial statement modeling, DCF, M&A, LBO, Comps and Excel Modeling. This industry will have a slightly longer collection period because the relationship between the supplier and buyer is built on mutual trust. The first formula is mostly used for calculation by investors and other professionals. In other words, Light Up Electric “turned over”—i.e., converted its AR into cash—21 times during the year.

The average collection period is also referred to as the days’ sales in accounts receivable. An alternative means of calculating the average collection period is to multiply the total number of days in the period by the average balance in accounts receivable and then divide by sales for the period. Calculating average collection period with average accounts receivable and total credit sales.

In the first formula, we need the average receiving turnover to calculate the average collection period, and we can assume the days in a year to be 365. The receivables turnover ratio is just like any other metric that tries to gauge the efficiency of a business in that it comes with certain limitations that are important for any investor to consider. In general, a higher receivable turnover is better because it means customers pay their invoices on time.

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