Looking On The Bright Side of Accounting
Get to Know the Common Accounting Terms and Formulas Accounts receivable turnover or AR turnover, also known as debtor’s turnover ratio, is the number of times in a year that a business accumulates its average accounts receivable. It is the ratio as well of net credit sales of a business to its average accounts receivable for a given period, usually a year. This is employed to assess the ability of the company to issue credit card efficiently to its customers and to timely collect funds from them. If the company has a high AR turnover ratio, it indicates that there is a combination of a conservative credit policy and an aggressive collections department on top of numerous high-quality customers. On the other hand, a low AR turnover ratio indicates that there is excessive old accounts receivable that need to be collected because they unnecessarily tie up the working capital. Normally, it is caused by several factors like a loose or nonexistent credit policy, an inadequate collections function, and/or a large proportion of customers that experiences financial difficulties. Moreover, it is a sign that there is an excessive amount of bad debt in the company. It is beneficial to track the AR turnover on a trend line for you to easily see if it is specially slowing down. This will decide if necessary actions need to be done like a review of why it is worsening. You need to use a formula that involves adding together the beginning and ending AR to arrive at the average AR for a particular measurement period then divide it into the net credit sales for the year.
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There are some cautionary items that you ought to think about when using this measurement. Some companies use the total sales in the numerator instead of the net credit sales, which lead to a misleading measurement where there is a high proportion of cash sales because there will be a higher amount of turnover than what is supposed to be. A very high AR turnover number indicates an extremely restrictive credit policy. This typically indicates that the credit manager merely allows credit sales to the most credit-worthy customers while letting competitors with looser credit policies to take away other sales.
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Because just two specific points in time during the measurement year are used, it is possible that there will be a considerable variation of the balances on these two dates. Thus, it is acceptable at times to use a different method to reach the average AR balance. One thing you can carry out is to apply the average ending balance for all the months of the year. A low AR number might not always be the mistake of the credit and collections staff only. It is possible that some errors made in other parts of the company have prohibited the payment. The blame for the poor measurement result should also be spread through the other parts of the business.