10 financial concepts you should master
Here is lesson three in unwrapping essential financial concepts and how they will help you run your business.
Accounts receivable ratio
Accounts receivable turnover is basically the number of times that your accounts receivable will be collected in a year. It is heavily influenced by the terms of trade in a business, which will vary depending on the firm, the sector and the terms negotiated with customers.
Some debtors pay within 30 days, others take 90 days. If your terms of trade were 30 days and you collected your accounts on time you would expect your accounts receivable ratio to be around 12.
We all know that many customers pay after the 30 days so the ratio will typically be lower. The lower the ratio the longer it is taking you to collect your cash.
This ratio measures effectiveness of the business in extending credit and collecting debts. It looks at the average days it takes to collect cash from the point of invoice.
The faster the business gets its money in the faster its cash flow cycle turns. The longer its customers take to pay the larger the negative impact on cash flow.
The ratio is determined by dividing the credit sales (where the customer is allowed pay on account at a later date rather than paying you in cash )by average accounts receivables (which is the typical amount of money you are expecting in from customers at any one time.) The formula is basic – annual credit sales divided by the company’s average balance in its accounts receivable account.
For example, you might have a store that sells $2 million of products a year on credit. The average receivables at any point in time is $200,000. That leaves you with a ratio of 10.
The higher ratio, the tougher the credit policy. A low ratio might indicate that there’s a collection problem and bad debts.
The ratio helps businesses to understand when they need to get money in quicker by tightening up their terms of trade. If a business can manage the terms of trade to ensure it is paid in 30 days, the business will have more working capital to build the business.
Another approach that some accountants use is to look at what they call accounts receivable days, where you measure the average amount of time it takes to collect money after a credit sale. Simply divide 365 days/turnover ratio, which in the example above shows it takes on average 36.5 days to collect your accounts receivable.
The accounts receivables ratio is not perfect and the ratio is an average only. The problem with that is that averages can hide important details. For example, some large outstanding debts could be “hidden” or offset by receivables that have paid faster than the average.
The ratio needs to be handled carefully but can be an early indicator that cash collections are falling short.