When a company sells goods (and/or services) and allows its customers to pay at a later

date, the company's accounts receivable or trade receivables will be increased at the time of
the sale. From the time of the sale until the money is received, the company is an unsecured
creditor of the customer. Therefore, every company needs to be cautious when shipping
goods on credit since it could result in a loss of both working capital and liquidity if the
company is not paid.

To assess a company's ability to convert its accounts receivable to cash during the prior
year, it is common to compute the following:

Accounts receivable turnover ratio

Average collection period (or days' sales in accounts receivable, and other names)
Accounts receivable turnover ratio
The accounts receivable turnover ratio (or receivables turnover ratio) relates the following
amounts:

the amount of net credit sales during a prior year

the average amounts in accounts receivable during the same year
To illustrate the calculation of the accounts receivable turnover ratio, let's assume that the
company's net credit sales during the most recent year were $1,000,000 and the average of
the balances in accounts receivable throughout the year amounted to $125,000. Based on
these amounts, we have:

Accounts receivable turnover ratio = net credit sales of $1,000,000 divided by the average
balance in accounts receivables of $125,000 = 8 times

This calculation tells us that on average the accounts receivable turned over 8 times during
the previous year.

This turnover ratio is an average because some of the accounts receivable may have turned
over (were collected) within 30 days of the sale, some within 31-60 days of the sale, and
some receivables continue to be past due for more than three months.

Caution when using amounts from annual financial statements

When the accounts receivable turnover ratio is calculated using amounts reported on a
company's published annual financial statements, there are some precautions:

The amounts reported in the financial statements reflect the transactions and balances that
occurred in a prior year. Business conditions may have changed since the time of those
transactions
Since the amounts on the financial statements are highly summarized, some unusual
transactions and amounts could be buried among the many routine transactions
A company's income statement may report only the total amount of sales without disclosing
the amount of net credit sales. As a result, some people will relate the reported total sales to
the average balance of the accounts receivable (which contains only the amount of the
unpaid credit sales). This is a problem when a significant portion of the company's sales
were for cash or involved credit and debit cards
The balance sheet reports the amount of accounts receivable as of the final moment of the
accounting year. Since U.S. companies often end their accounting year at the slowest time
of their business year, the end-of-the-accounting-year balances are not indicative of the
receivable balances in the months when there is much more business activity. This is the
reason for using the average amount of accounts receivable during the entire year.
Averaging two end-of-the-accounting-year balances does not resolve this problem.
Below is a chart illustrating why using only the final moment at the end of one or two
accounting years can lead to a distorted accounts receivable turnover ratio and the related
average collection period. In the following example, the company has a seasonal business
with a busy season from May through October.