Sales are great, but if customers don't pay on time, the sales aren't worth much to a business and their financial reports. In fact, someone who doesn't pay for the products he takes is no better for business than a thief. When you're assessing a company's future prospects, one of the best ways to judge how well it's managing its cash flow is to calculate the accounts receivable turnover ratio.
A balance sheet lists customer credit accounts under the line item Accounts receivable. Any company that sells its goods on credit to customers must keep track of whom it extends credit to and whether those customers pay their bills.
Financial transactions involving credit card sales aren't figured into accounts receivable, but are handled like cash. The type of credit this refers to is in-store credit. In this case, the bill the customer receives comes directly from the store or company where the customer purchased the item.
When a store makes a sale on credit, it enters the purchase on the customer's credit account. At the end of each billing period, the store or company sends the customer a bill for the purchases she made on credit.
The customer usually has between 10 and 30 days from the billing date to pay the bill. When you calculate the accounts receivable turnover ratio, you're seeing how fast the customers are actually paying those bills.
How to calculate accounts receivable turnover
Here's the three-step formula for testing accounts receivable turnover:
Calculate the average accounts receivable:
Find the accounts receivable turnover ratio:
Net sales ÷ Average accounts receivable = Accounts receivable turnover ratio
Find the average sales credit period (the time it takes customers to pay their bills):
52 weeks ÷ Accounts receivable turnover ratio = Average sales credit period
If you work inside the company, an even better test is to use annual credit sales instead of net sales because net sales include both cash and credit sales. But if you're an outsider reading the financial statements, you can't find out the credit sales number.
You can test accounts receivable turnover by using Mattel's and Hasbro's 2012 income statements and balance sheets.
Mattel
Calculate the average accounts receivable:
($1,226,833,000 + $1,029,959,000) ÷ 2 = $1,236,760,000
Find Mattel's accounts receivable turnover ratio for 2012:
$6,420,881,000 (Net sales) ÷ $1,236,760,000 (Average accounts receivable) = 5.19 times
Find the average credit collection period:
52 weeks ÷ 5.19 (Accounts receivable turnover ratio) = 10.02 weeks
Mattel's customers averaged about 10.2 weeks to pay their bills.
Comparing this data with the previous year's is a good way to see whether the situation is getting better or worse. If you use the same process to calculate Mattel's 2011 average credit collection period, you find that the answer is 5.07 weeks, meaning that the company took slightly longer in 2011 to collect than it did in 2012.
To understand the significance of this, look at what's happening with similar companies, as well as what's happening within the industry as a whole. It may be an internal company problem, or it may be an industry-wide problem related to changes in the economic situation.
Hasbro
Calculate Hasbro's average accounts receivable:
($1,029,959,000 + $1,034,580,000)/2 = $1,032,270,000
Calculate Hasbro's accounts receivable turnover ratio for 2012:
$4,088,983,000 (Net sales) ÷ $1,032,270,000 (Average accounts receivable) = 3.96 times
Calculate the average sales credit period:
52 weeks ÷ 3.96 (Accounts receivable turnover ratio) = 13.13 weeks
Hasbro's accounts receivable turned over at a rate slower than Mattel's.
Is that an improvement or a step backward for Hasbro? Using the 2011 numbers, you find that Hasbro took 12.52 weeks to collect from its customers. So the company experienced deterioration in its accounts receivable collection.
What do the numbers mean?
The higher an accounts receivable turnover ratio is, the faster a company's customers are paying their bills. Most times, the accounts receivable collection is directly related to the credit policies that the company sets. For example, a high turnover ratio may look very good, but that ratio may also mean that the company's credit policies are too strict and that it's losing sales because few customers qualify for credit.
A low accounts receivable turnover ratio usually means that a company's credit policies are too loose, and the company may not be doing a good job of collecting on its accounts. In the case of Mattel and Hasbro, the slow pay rates may be indicative of the economic environment in the toy industry since the 2008 bubble burst, not a major problem with their credit approval processes.