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Accounts receivable are a very important part of the current assets of any business. Like inventory, accounts receivable are considered a necessary evil to do business. Large companies hardly conduct any transactions on cash basis with their wholesalers and distributors. The transactions are largely conducted on credit and therefore lead to the existence of accounts receivable on the balance sheet.
Accounts receivable are a dangerous item. If the firm is taking too long to collect the accounts receivable, it means that the firm is not utilizing its capital in the best possible way. Buyers are using the firms interest free credit and making delayed payments to the firm which has to arrange for working capital at a cost. Also the older accounts receivable become, the less likely they are to be collected. Hence, accounts receivable turnover ratio is a closely watched number.
Accounts Receivable Turnover Ratio = Net Credit Sales / Average Accounts Receivable*
Average Accounts Receivables = (Beginning Accounts Receivables + Ending Accounts Receivables) / 2
This formula converted to a percentage shows the average amount of receivables that the firm has at any given point of time. Let’s say the answer was 27%, it would mean that on an average the firm has 27% of its receivables outstanding at any given point of time.
The number of days of receivables outstanding is considered by many to be a different ratio when in reality it is just an extension of the same ratio. In the above case we have reached an answer expressed in terms of percentage. All we need to do is to convert the answer to the number of days. Lets use the above example to understand how the number of days is calculated.
Number of Days Receivables Outstanding = (27 / 100) * 360
*For the purpose of calculation of ratios accountants assume that the year has 360 days.
The answer to the above is 97.2 days. The firm therefore turns over its receivables every 97.2 days. This means that the old receivables are replaced by a new set of receivables every 97.2 days. Therefore in 360 days, the receivables are turned over (360/97.2) 3.7 times.
The accounts receivables ratio is a good indicator of the bargaining power that a firm has amongst its buyers. If the firm has good bargaining power, there will be less receivable outstanding and the turnover will be higher.
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