Accounts Receivable: Turnover, Other
When a company sells goods (and/or services) and allows its customers to pay at a later date, the company's accounts receivable or trade receivables will be increased at the time of the sale. From the time of the sale until the money is received, the company is an unsecured creditor of the customer. Therefore, every company needs to be cautious when shipping goods on credit since it could result in a loss of both working capital and liquidity if the company is not paid.
To assess a company's ability to convert its accounts receivable to cash during the prior year, it is common to compute the following:
- Accounts receivable turnover ratio
- Average collection period (or days' sales in accounts receivable, and other names)
Accounts receivable turnover ratio
The accounts receivable turnover ratio (or receivables turnover ratio) relates the following amounts:
- the amount of net credit sales during a prior year
- the average amounts in accounts receivable during the same year
To illustrate the calculation of the accounts receivable turnover ratio, let's assume that the company's net credit sales during the most recent year were $1,000,000 and the average of the balances in accounts receivable throughout the year amounted to $125,000. Based on these amounts, we have:
Accounts receivable turnover ratio = net credit sales of $1,000,000 divided by the average balance in accounts receivables of $125,000 = 8 times
This calculation tells us that on average the accounts receivable turned over 8 times during the previous year.
This turnover ratio is an average because some of the accounts receivable may have turned over (were collected) within 30 days of the sale, some within 31-60 days of the sale, and some receivables continue to be past due for more than three months.
Caution when using amounts from annual financial statements
When the accounts receivable turnover ratio is calculated using amounts reported on a company's published annual financial statements, there are some precautions:
- The amounts reported in the financial statements reflect the transactions and balances that occurred in a prior year. Business conditions may have changed since the time of those transactions
- Since the amounts on the financial statements are highly summarized, some unusual transactions and amounts could be buried among the many routine transactions
- A company's income statement may report only the total amount of sales without disclosing the amount of net credit sales. As a result, some people will relate the reported total sales to the average balance of the accounts receivable (which contains only the amount of the unpaid credit sales). This is a problem when a significant portion of the company's sales were for cash or involved credit and debit cards
- The balance sheet reports the amount of accounts receivable as of the final moment of the accounting year. Since U.S. companies often end their accounting year at the slowest time of their business year, the end-of-the-accounting-year balances are not indicative of the receivable balances in the months when there is much more business activity. This is the reason for using the average amount of accounts receivable during the entire year. Averaging two end-of-the-accounting-year balances does not resolve this problem.
Below is a chart illustrating why using only the final moment at the end of one or two accounting years can lead to a distorted accounts receivable turnover ratio and the related average collection period. In the following example, the company has a seasonal business with a busy season from May through October.
If the average accounts receivable is based on the two end-of-accounting-year balances shown above, the average accounts receivable will be $9,000 (8 + 10 = 18 divided by 2).
However, if the average accounts receivable is based on the beginning balance for January plus the 12 end-of-month balances during the entire accounting year, the average accounts receivable is calculated to be $32,923 (8+10+10+10+20+40+50+70+70+60+40+30+10 = 428 divided by 13).
This shows why a company's current, detailed accounts receivable records will provide more precision than the summary amounts found in financial statements from an earlier year. Unfortunately, the people outside of a company will not have access to the current, detailed information.
Average collection period
Related to the accounts receivable turnover ratio is the average collection period. As the name indicates this is the average number of days of credit sales that were in accounts receivable during a past year. The average collection period is also known as: days' sales in accounts receivable, days' sales in receivables, days' sales uncollected, days to collect, etc.
When the accounts receivable turnover ratio is known, the average collection period is easy to compute:
Average collection period = 360 or 365 days in a year divided by the accounts receivable turnover ratio
Using the accounts receivable turnover rate of 8 times, the average collection period is:
Average collection period = 360 or 365 days divided by 8 times = 45 days or 45.6 days
The average collection period of 45 days will be one component of the operating cycle that we presented earlier:
Again, the 45 or 45.6 days is an approximation since the average was based on amounts during the prior year. Keep in mind that some customers may have paid early, some paid near the due date, some paid a week or two weeks late, some paid more than a month late.
Aging of accounts receivable
An aging of accounts receivable is an internal report which sorts a company's accounts receivable (unpaid sales invoices) according to the date when the customers' payments are or were due. Amounts that are not yet due will be placed in a column with the heading "Current". Amounts that should have already been paid are sorted into the appropriate columns with headings such as "1-30 days past due", "31-60 days past due", "61-90 days past due" and so on.
Even inexpensive accounting software will allow the smallest of businesses to generate an aging of accounts receivable with a click of a mouse. This allows the authorized people within a company to quickly see the specific customers that are current or are past due in paying the amounts that are owed to the company. The aging of accounts receivable also allows a company to easily monitor customers who attempt to ignore the stated credit terms. Monitoring the accounts receivable is important since a company's liquidity depends on converting its accounts receivable to cash in time to pay its current liabilities when they are due. As a general rule, you should assume that the longer an account receivable is past due, the less likely that the full amount will be collected.
Cash discounts for early payment
Some companies offer cash discounts to encourage its credit customers to pay the amounts owed within 10 days instead of paying in the required 30 days. These discounts are referred to as early payment discounts or cash discounts. Two common examples of early payment discounts are:
- 1/10, net 30. This means the net amount (the invoice amount minus any authorized returns or allowances) is to be paid in 30 days. However, a 1% cash discount is allowed if the invoice is paid within 10 days. For example, if an invoice is $2,150 and the customer returned $50 of goods, the net amount owed is $2,100. Therefore, if the customer pays the company within 10 days, the customer may deduct 1% of $2,100 and remit only $2,079 ($2,100 minus $21).
- 2/10, net 30. This means that the customer may deduct 2% of the net amount owed, provided the customer remits the payment in 10 days instead of paying in 30 days. Hence, if the net amount is $2,100 it can be satisfied with a remittance of $2,058 ($2,100 minus $42) if it is paid within 10 days.
Unfortunately for the companies offering the early payment discounts, some customers will take the discount but will not remit within the 10-day discount period.
Many companies will not offer early payment discounts because of the high cost. For instance, "2/10, net 30" means a 2% deduction is given for paying 20 days early (the customer must pay in 10 days instead of the required 30 days). Saving (or earning) $42 by paying $2,058 just 20 days sooner is an annualized return of 36% per year.
If the company uses the $2,058 every 20 days and saves $42 each time, the company will earn approximately $756 in a year. This equates to an annual return of 36.7% ($756/$2,058). More simply, multiplying both the 2% and the 20 days by "18" gives you 36% for a 360-day year.
Another way to see the magnitude of the early-payment discount is to assume you had to borrow the needed $2,058 at an annual interest rate of 6%. The amount you will pay in interest will be approximately $7 ($2,058 X 6% per year = $123.48 X 20/360 days). A company will pay interest of only $7 in order to receive the $42 early payment discount.
Requiring new and smaller customers to use a credit card
Some companies realize there is a cost for:
- Investigating whether a potential customer is a good credit risk
- Processing customer remittances
- Following up on unpaid amounts
- Not collecting the amount owed by the customer
When a customer uses a business credit card, the customer will be given 27 to 57 days in which to pay the credit card company. In addition, the customer may receive a 2% cash rebate from the credit card company.
Even though the company selling the goods and services will have to pay a fee of perhaps 3-5% to the credit card processors, the seller gets the following benefits:
- Getting the money deposited in its checking account within a few days of the transaction
- Avoiding the costs already described, and
- Improving the company's liquidity by avoiding an account receivable.
Working with bankers, asset-based lenders, factors
It is immensely important to have a good business relationship with your banker. This includes frequent communication regarding your business's financial situation and the actions being taken to have the necessary working capital and liquidity. In the process you will learn how your banker can assist with your company's financing.
Your banker will inform you whether your company qualifies for a bank line of credit. If your company qualifies for a preapproved line of credit that can be used when needed, you will have less stress by not worrying about daily bank balances and/or having to arrange for a loan when an emergency occurs.
If your banker is unable to provide financing, the banker may advise you where you can turn to for the needed financial assistance. For example, your banker may welcome working with an asset-based lender or a factor who purchases accounts receivable. Both the asset-based lender and the factor may advance cash equal to 85% of a company's receivables.
Since your banker's suggestions, advice, and understanding are valuable, establish the communication before your company experiences financial difficulty.
To learn more see our topic Accounts Receivable and Bad Debts Expense.