Glancing over the financial statements of a small business, many entrepreneurs will see the names of several accounts and not understand what they are and the importance to their company. For instance, revenue, accounts receivable, interest expense, and cost of goods sold accounts are probably shown on every income statement but what do they mean and how are they used to make a business more profitable? One of these, accounts receivable, delivers unparalleled insight into the company’s ability to follow-up on credit sales. So, what exactly are accounts receivable, how are they created, and how is the accounts turnover ratio interpreted?
Buy Now, Pay Later
What facilitates the creation of accounts receivable are sales that the customers do not pay for immediately. For instance, a vehicle company could sell car parts to a nationwide retailer in return for a payment made within the following 30 days. Once this transaction is recorded through a journal entry, the vehicle company is considered to have extended a credit line to their buyer instead of taking cash. Now, their accounts receivable balance will increase on the balance sheet until such a time that this debt is paid off.
Collection period for accounts receivable follows no specific guidelines as every organization establishes their set of rules. Usually, however, businesses will allow a 30-day grace period before the payment is considered late. Eventually, the lack of payment will constitute a bad debt expense as the company will have to erase this credit line due to a low likelihood of payment. Unfortunately, bad debt goes against the bottom line of most corporations as it directly reduces the profits.
What is the purpose of the accounts receivable turnover ratio?
The reason why a small business owner should be mindful of this ratio is that it provides important information about the company’s cash flow management efficiency. For instance, if a business has credit sales of 90 percent and has an accounts receivable ratio of 0.25, they collect their debt once in every four years. If a business has too much money tied up in accounts receivable, they may face a cash shortage or increased risk of non-payment.
Ratios Offer Incredible Insight
One of the major advantages of knowing how to interpret financial statements boils down to one’s ability to calculate financial ratios. Although there is a long list of useful formulas, the accounts receivable turnover ratio is ranked very high. This is because of its ability to numerically depict some firm’s timeliness when it comes to recovering collection of unpaid exchanges. To grasp this concept fully, however, one must know the formula used to derive the turnover for accounts receivable.
First, the net credit sales must be calculated. This number will exclude all returns and allowances granted by the company as they represent forgiven charges. Then, the net credit sales are divided by the average accounts receivable over a certain period. As with every other average in accounting, one simply divides the sum of the beginning and ending balance by two. Thus, if a company has $500,000 in net credit sales, $200,000 in beginning, and $300,000 in ending accounts receivable, their turnover ratio is 2. In translation, they collect the entire outstanding debt approximately twice a year.
Analyzing the Ambiguous Data
Unfortunately, the insight that the turnover ratio provides is not entirely black and white. On the contrary, there is a number of explanations that could clarify why some company has a high or low ratio related to their accounts receivable turnover. For instance, a high ratio could point out any of the following:
- The company does not use accounts receivable as the credit lines are not offered. In translation, they only accept cash payments.
The collection policies of outstanding debt are extremely strict and successful.
The approval of consumer credit is very rare.
Based on the aforementioned, a lender could interpret the data as an advantage of loaning money to the business since they have outstanding collection procedures. Simultaneously, however, they may interpret it as nothing more than some company’s unwillingness to accept any non-cash payments.
Similarly, a ratio analysis showing a low accounts receivable turnover ratio could be a subtle hint for any of the following:
- The company does a poor job with credit checks before extending credit lines to consumers who seldom pay.
There is one enormous buyer that failed to pay their credit line and, in turn, completely skewed the data.
In reality, there is only one benefit of a low accounts receivable turnover ratio. It is the fact that it indicates how companies have cash that their buyers owe them. Thus, an improvement in collection practices could lead to an ultimate increase in cash flows.
Aiming for a Higher Number
In the vast majority of financial scenarios, businesses should aim for a higher turnover ratio when it comes to their outstanding debt. If it is low, it depicts the business as incapable of efficiently operating in the long-run. After all, ever-growing accounts receivable will reduce the inflow of cash and jeopardizing its liquidity position. When high, however, this financial ratio assures banks that the company confidently turns over the debt owed to them.
It also speaks volumes about their credit-related practices as they have a sufficient background and credit check that facilitates trust-worthy buyers. From there, the business owner can better forecast profits and not fall victim to unpredictable collection practices!