9.3 Determine the Efficiency of Receivables Management Using Financial Ratios

You received an unexpected tax refund this year and want to invest the money in a profitable and growing company. After conducting research, you determine that it is important for a company to collect on outstanding debt quickly, while showing a willingness to offer customers credit options to increase sales opportunities, among other things. You are new to investing, so where do you begin?

Stakeholders, such as investors, lenders, and management, look to financial statement data to make informed decisions about a company’s financial position. They will look at each statement—as well as ratio analysis—for trends, industry comparisons, and past performance to help make financing determinations. Because you are reviewing companies for quick debt collection, as well as credit extension to boost sales, you would consider receivables ratios to guide your decision. Discuss the Role of Accounting for Receivables in Earnings Management will explain and demonstrate two popular ratios—the accounts receivable turnover ratio and the number of days’ sales in receivables ratio—used to evaluate a company’s receivables experiences.

It is important to remember, however, that for a comprehensive evaluation of a company’s true potential as an investment, you need to consider other types of ratios, in addition to the receivables ratios. For example, you might want to look at the company’s profitability, solvency, and liquidity performances using ratios. (See Appendix A for more information on ratios.)

Figure 9.3 Which Company Is the Best Investment? Receivables ratios can help make this determination. (credit: “Black Laptop Computer Showing Stock Graph” by “Negative Space”/Pexels, CC0)

Basic Functions of the Receivables Ratios

Receivables ratios show company performance in relation to current debt collection, as well as credit policy effect on sales growth. One receivables ratio is called the accounts receivable turnover ratio . This ratio determines how many times (i.e., how often) accounts receivable are collected during an operating period and converted to cash (see Figure 9.3). A higher number of times indicates that receivables are collected quickly. This quick cash collection may be viewed as a positive occurrence, because liquidity improves, and the company may reinvest in its business sooner when the value of the dollar has more buying power (time value of money). The higher number of times may also be a negative occurrence, signaling that credit extension terms are too tight, and it may exclude qualified consumers from purchasing. Excluding these customers means that they may take their business to a competitor, thus reducing potential sales.

In contrast, a lower number of times indicates that receivables are collected at a slower rate. A slower collection rate could signal that lending terms are too lenient; management might consider tightening lending opportunities and more aggressively pursuing outstanding debt. The lower turnover also shows that the company has cash tied up in receivable longer, thus hindering its ability to reinvest this cash in other current projects. The lower turnover rate may signal a high level of bad debt accounts. The determination of a high or low turnover rate really depends on the standards of the company’s industry.

Another receivables ratio one must consider is the number of days’ sales in receivables ratio . This ratio is similar to accounts receivable turnover in that it shows the expected days it will take to convert accounts receivable into cash. The reflected outcome is in number of days, rather than in number of times.

Companies often have outstanding debt that requires scheduled payments. If it takes longer for a company to collect on outstanding receivables, this means it may not be able to meet its current obligations. It helps to know the number of days it takes to go through the accounts receivable collection cycle so a company can plan its debt repayments; this receivables ratio also signals how efficient its collection procedures are. As with the accounts receivable turnover ratio, there are positive and negative elements with a smaller and larger amount of days; in general, the fewer number of collection days on accounts receivable, the better.

To illustrate the use of these ratios to make financial decisions, let’s use Billie’s Watercraft Warehouse (BWW) as the example. Included are the comparative income statement (Figure 9.4) and the comparative balance sheet (Figure 9.5) for BWW, followed by competitor ratio information, for the years 2016, 2017, and 2018 as shown in Table 9.1.

Figure 9.4 Comparative Income Statements for Billie’s Watercraft Warehouse for the Years 2016, 2017, and 2018. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

Figure 9.5 Comparative Income Statements for Billie’s Watercraft Warehouse for the Years 2016, 2017, and 2018. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)