Accounting: The Language of Business (Part 47)

“There’s no accounting for laws. Or the changes wrought by men and time.” —James Crumley

Receivables (Part F)

by

Charles Lamson

Financial Analysis and Interpretation

Businesses that grant long credit terms tend to have relatively greater amounts tied up in accounts receivable than those granting short credit terms. In either case, it is desirable to collect receivables as promptly as possible. The cash collected from receivables improves solvency and lessens the risk of loss from uncollectible accounts. Two financial measures that are especially useful in evaluating the efficiency in collecting receivables are (1) the accounts receivable turnover and (2) the number of days sales in receivables.

The accounts receivable turnover measures how frequently during the year the accounts receivable are being converted to cash. For example, with credit terms of 2/10 (read as 2% discount if the buyer pays within 10 days), n/30 (read as net amount due within 30 days), the accounts receivable should turn over less than 36 times per year. The accounts receivable turnover is computed as follows:

Accounts receivable turnover = Net sales / Average accounts receivable

The average accounts receivable can be determined by using monthly data or by simply adding the beginning and ending accounts receivable balances and dividing by 2. For example, assume that Sidner Company offers credit terms of 2/10, n/30 and has net sales of $36,000,000 and beginning and ending accounts receivable balances of  $1,080,000 and $1,220,000. The accounts receivable turnover is 31.3, as shown below.

Accounts receivable turnover = Net sales / Average accounts receivable

= $36,000,000 / ($1,080,000 + $1,220,000) / 2 = 31.3

The number of days sales in receivables is an estimate of the length of time the accounts receivable have been outstanding. With credit terms of 2/10, end / 30 days come, the number of days sales in receivables should be more than 10 days. It is computed as follows:

Number of days sales in receivables = Accounts receivable, end of year / Average daily sales

Average daily sales is determined by dividing net sales by 365 days. For example, using the preceding data for Sidner Company, the number of days sales in receivables is 12.4, as shown below.

Number of days sales in receivables = Accounts receivable, end of year / Average daily sales

= $1,220,000 / ($36,000,000 / 365 days) = 12.4

For these measures to be meaningful, a company should compare its current measures with those from prior periods and with industry figures. An improvement in the efficiency in collecting accounts receivable is indicated when the accounts receivable turnover increases and the number of days' sales in receivables decreases. 

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 330-331*

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