Financial Ratios Series – Activity Ratios Part 2

“Some people dream of great accomplishments, while others stay awake and do them.” Anonymous

Accounts Receivable Turnover

This is a widely used ratio as it is a very important metric to watch. The A/R Turnover ratio measures how many times outstanding receivables from sales are collected each year. Because it’s an average, this ratio does not take into account seasonality of sales. It assumes that all sales happen evenly throughout the year.

When calculating this ratio, be sure to exclude all cash sales. This ratio is intended for credit sales only. The ratio is calculated as follows:

A/R Turnover: Annualized Credit Sales / Average Accounts Receivable

 For example, if ABC company had 1 million in sales last year and an average accounts receivable of 200,000, their A/R Turnover ratio would be 5 (1,000,000 / 200,000). This ratio finds its meaning when compared to an industry average, to a competitor or when looked at over a trend.

Day’s Sales in Accounts Receivable (DSO) 

The A/R turnover ratio can also be analyzed in days instead of times per year. Continuing with the example above, if the turnover ratio is 5, how can we translate that into days? By using the following formula:

DSO: 365 / AR Turnover

365 stands for the number of days in a year. So if the turnover ratio is 5, then the DSO for ABC company is 73 days (365 / 5). This means that it takes 73 days for ABC to collect its outstanding receivables. Just like with the A/R turnover ratio, DSO is meaningful when compared to the industry average, to a competitor, or over a trend.

I hope you found this post helpful. If you have any questions or comments, drop them in the comments section below. I’ll respond as soon as possible.

In the next post, we’ll learn how to measure inventory management effectiveness.

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