The ratio itself is fairly simple. Take a business’s annual sales turnover and divide it by the average balance of the accounts receivable (AR) over the same period. For example, if annual sales turnover is £2,000,000, average AR balance is £ 250,000 (2,000,000/250,000), the accounts receivable is 8. The resulting figure gives an indication that on average, the business turned over its accounts receivable eight times over the course of the year.
What does this tell me?
The number eight may not mean an awful lot to anyone unfamiliar with accounting ratios. However, it does provide the basis to drill down even further. By dividing the number of days in the year (360 or 365 will suffice) by the number eight, we arrive at another figure of 45. These two simple sums tell us that accounts receivable turned over eight times during the year or, put another way, every 45 days.
Is this good?
To make any real use of this information, it is important to know three other things: how it compares to the industry standard, how it compares to prior years and how it compares to the business’s actual credit policy. If sales turnover is generated on the basis of 30 days credit, then on average, debts are being collected 15 days past due. On the other hand, if the business sells on 60-day terms, it clearly has a robust trade receivables department.
Where can I find the necessary information?
Any well run business will close down their books on a monthly basis and prepare accounts covering this period. 12 months sales turnover figures gives the total sales for the year and by noting each month ends accounts receivable balance, it is easy to arrive at an average monthly figure.
Remember, it is only an average
Whilst undoubtedly a useful starting point, you should always bear in mind that any yearly average ratio can mask certain anomalies. For instance, many of very fast moving debt will offset any overdue or even delinquent debt in the figures. In this respect, and whilst you have access to a business’s books, it would be very worthwhile looking at a detailed aged receivables report.
Do not stop there though, with 12 months figures at hand, why not do a days sales outstanding calculation for different periods of the year and compare them to the annual average?
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