The account receivable turnover ratio is gonna tell you how many times in a given year or quarter whatever the period is that a company collects its average account receivable balance. To calculate this here’s the formula, you’re basically gonna take the net credit sales, this is not just a total sales revenue because total sales revenue is gonna include cash sales. So if at all possible you want to get the net credit sales and we would subtract out sales return, sales discounts, and so forth. We’ve got net sales which is just gross sales – sales discounts, sales returns and allowances, and so forth but then we’re actually gonna also subtract out the cash sales. We don’t want cash in there because what we’re trying to do is measure how quickly how many times in a period a company is collecting its receivables. So we take the net credit sales and we divide that by the average net accounts receivable.
So Net accounts receivable, you’ll see it on the balance sheet as AR/, net. That’s just the account receivable – the allowance for doubtful accounts. When I say average let’s say you were doing this for a year for a company then you would take their annual net credit sales for that year and then you would take from the beginning of the year you would take their net account receivable balance and then from the end of the year, so you look at from balance sheet date to balance sheet date take them and divide it by two.
So let me give you an example it’ll make this a little bit easier for you to understand, so let’s say that we have a company called woofer that makes mechanical dogs as pets. You don’t have to clean up them or walk them so woofer had 20 million dollars in total net sales revenue during 2021. But only 15 million of those sales were made on credit. So we’re talking about total net sales was 20 million dollars so we’ve already taken out sales discount, sales returns allowances we don’t have to worry about that and of that 20 million, 15 million was on credit. That’s gonna be in the numerator here when we go to calculate this ratio.
Now to get the denominator we have to say what was the net account receivable at the beginning of the year. Let’s say it was 4 million dollars and then at the end of the year it was 2 million dollars. So what we do is we just take the four + two and divide it by two to get the average. So six divided by two is 3. So our denominator is gonna be 3 and then our numerator is going to be 15.
So we can see that the account receivable turnover ratio for this company is gonna be 5. Now, what does that mean? That means that this company woofer collects its account receivable about five times a year. So now that you have that information what can you do with it? Well, you can look and say okay, “Compared to other firms in this industry how is woofer doing? Does it collects receivables a lot more times in a given year than its competitors or a lot fewer times?” Then you can also look at a trend analysis over time. Let’s say that the previous year the ratio was six, the previous year was seven, the previous year was eight like if we go back in time, and then this year was five so we see that there’s a trend there over time we’re collecting our receivables a lot fewer times each year.
So it could be a couple of reasons that decrease in this ratio happening. Now one is maybe the company relaxed its credit policy, so sometimes when companies get in financial trouble one way to boost sales is to just start extending credit to pretty much anyone. So if they have new customers that aren’t really very creditworthy it could be that those customers they come in and even though we have quote a sale it’s never being collected. The other reason is, it’s taking a long time to collect. Now it also could be that the company didn’t necessarily relax its credit policy but maybe it’s just that the existing customers are taking a longer amount of time to pay their bill or maybe they’re not paying at all. So what we’re trying to do with this ratio is see how good a job is a company doing with that.