The receivable turnover ratio is generally used by banks and creditors. Receivables are current assets which are expected to be converted into cash during the next business cycle. Receivable turnover ratio measures the effectiveness of company’s receivable collection policy. In other words, it indicates how many times the receivables are converted into cash in a given period of time, usually a year.
*Daily Credit Sales
Daily Credit Sales = Net Credit Sales per year / 365 per year
Credit sales are a way of selling products on credit basis with certain terms attached. Credit terms include credit period, discount allowed if cash is paid before due date and interest charged if credit is not paid before due date. Similarly, companies make purchases on a credit basis, which are included as accounts payable on the balance sheet. It is generally assumed that a company will satisfy their accounts payable with their accounts receivable.
Low receivable turnover rates may indicate that the receivables are not being collected reasonably in accordance with the credit terms. The company may face severe liquidity issues if its receivables are excessively slow in being converted into cash. Directly related to the receivable turnover ratio is the average collection period which represents the number of days that credit sales are locked in accounts receivables. It is calculated as:
The average collection period should be compared to the company’s credit terms to judge the efficiency of its credit management. If the average collection period is longer than the credit period allowed by the company, it indicates weak collection efforts on the part of the company. However, an average collection period that is shorter than the credit period allowed by the company is not always a good sign. It may also indicate excessive conservatism in credit granting that may result in the loss of sales.