Page 167 - CalcBus_Flipbook

CH 20] Calculating Business 20-11

Accounts Receivable Turnover Ratio. Accounts receivable occur when a firm
offers credit to its customers, and thus, they build accounts receivable which must be
collected after their sales. Firms offer their own credit services to increase their profits.
Instead of relying on bank credit cards, large firms offer their own credit services and issue
a credit card of their own. Sometimes this is done in conjunction with a credit firm such as
Master Card or Visa, and some companies will offer their customers their corporate credit
card such as J.C. Penney, Sears, Lowes, or Amazon.com. When a company establishes its
own credit card service, it engages in managing those clients and customer accounts.
Some firms collect their receivables within 90 days and others take up to 6 months to
collect. The accounts receivable turnover ratio is an efficiency ratio that shows how efficient
the firm is at collecting on its credit sales from customers. As it is an efficiency ratio, it
measures how many times the firm can turn its accounts receivable into cash during a
period. 20
A turn refers to each time a company collects its average receivables. If a company has
$40,000 on average of receivables during the year and collected $80,000 during the year,
the firm would have turned its accounts receivable twice ($80,000 ÷ $40,000 = 2) because it
collected twice on the amount of average receivables. The equation for this calculation is:

Net Credit Sales
Accounts Receivable Turnover Ratio = ———————————————

Average Accounts Receivable

Net Credit Sales are used instead of Net Sales, the reason being is that cash sales don’t
create receivables. Only credit sales establish a receivable; so the cash sales are left out of
the calculation. Net sales simply refers to sales minus returns and refunded sales. Presume
a firm reports on its income statement revenues as:
Cash Sales $350,000
Credit Sales $450,000
Less: Returns & Allowances $ 25,000
Net Sales $775,000

Average Accounts Receivable is calculated by adding the beginning and ending
receivables for the year and dividing by two. This yields an approximate calculation for the
average receivables for the year.
As this receivables turnover ratio measures the firm’s ability to collect on its receivables,
a higher ratio is more favorable. A high ratio indicates that the firm is collecting on its
receivables more frequently throughout the period of time being measured.

Example: Outdoorman is a retail store selling outdoor equipment and it offers credit
accounts to all of its main customers. At the end of the year, Outdoorman’s
balance sheet shows $20,000 in accounts receivable, $75,000 of gross
credit sales, and $25,000 of returns. Last year’s balance sheet showed
$10,000 as accounts receivable. Calculate (a) Net Credit Sales, (b) Average
Accounts Receivable, and (c) the firms Accounts Receivable Turnover Ratio.

Solution algorithm:
(a) Net Credit Sales = Gross Credit Sales – Returns & Allowances
$50,000 = $75,000 – $25,000

Beginning Accounts Receivable + Ending Accounts Receivable
(b) Average Accounts Receivable = ———————————————————————————————
2

$20,000 + $10,000
$15,000 = ——————————
2

Net Credit Sales
(c) Accounts Receivable Turnover Ratio = —————————————-
Average Accounts Receivable
$50,000
3.33:1 = —————
$15,000

Analysis: This ratio indicates that Outdoorman collects their receivables on average
3.33 times a year or once every 120 days. That is to say Outdoorman will take 120 days to
collect the cash from a credit sale.
Copyrighted Material