So let's discuss a ratio here real quick, the accounts receivable turnover ratio. The accounts receivable turnover ratio relates the amount of sales, specifically the net credit sales, to our average accounts receivable level. This common efficiency ratio helps us understand how efficiently we extend credit to our customers and how long it takes for them to pay us back.
Let's go right in and calculate our accounts receivable turnover. In our numerator, we have net credit sales (note that "credit" is in parenthesis since a problem might not specifically mention credit sales—they might just tell you net sales or sales revenue). In our denominator, we have our average accounts receivable balance. To calculate an average balance, it is always calculated as the beginning balance plus the ending balance divided by 2. That's exactly what we have here in our denominator, i.e., beginning AR plus ending AR divided by 2.
So how do we analyze the AR turnover ratio? It tells us how many sales dollars we get for each dollar of credit we extend. For each dollar of credit extended, how many times can we generate a credit sale from it? It represents a constant flow of extending credit and receiving payments from customers who previously owed money, hence maintaining some average balance.
How do we determine if our AR turnover ratio is good or bad? Like many other ratios, we use benchmarking, understanding the nature of our industry. Depending on whether our industry relies heavily on credit or can operate predominantly on cash transactions, our AR turnover ratios will vary. Higher turnover ratios generally mean that you're being very efficient with extending credit to your customers.
However, an abnormally high AR turnover could signal that your credit terms are too restrictive, which might deter good potential customers who need more flexible credit terms, perhaps a reselling business dealing with wholesalers who need time to sell their products.
Let's calculate an AR turnover ratio with a practical example. Let's say XYZ Company had net sales of 500,000. If the beginning balance of AR was 75,000 and the ending balance of AR was 25,000, then the average AR would be calculated as (75,000 + 25,000) / 2 = 50,000. With net sales as the numerator, we get an AR turnover ratio of 500,000 / 50,000 = 10. This indicates that for every dollar of credit extended, the company turns it into 10 dollars of sales.
Now, go ahead and try the practice problem coming up.
