Interval Measure Ratio, Debtors Turnover Ratio and Creditors Turnover Ratio
Definition
A calculation to measure the approximate number of days a company could operate simply on the cash it currently has on hand. It is equal to quick assets divided by daily operating expenses, and the value it returns is the average number of days that company could use those assets to meet all its expenses. The interval measure is similar to both the current ratio and the quick ratio, in that it gives an idea of how easily a company could fulfill its obligations. The interval measure is sometimes preferred to the other ratios because it returns an approximation of the actual number of days, as opposed to the other ratios, which just return a value that indicates the ease of making the payments.
| Interval Measure |
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Liquid AssetsAvg.Daily Operating Expenses
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What is the 'Receivables Turnover Ratio'
The receivables turnover ratio is an accounting measure used to quantify a firm's effectiveness in extending credit and in collecting debts on that credit. The receivables turnover ratio is an activity ratio measuring how efficiently a firm uses its assets.
Receivables turnover ratio can be calculated by dividing the net value of credit sales during a given period by the average accounts receivable during the same period. Average accounts receivable can be calculated by adding the value of accounts receivable at the beginning of the desired period to their value at the end of the period and dividing the sum by two.
The method for calculating receivables turnover ratio can be represented with the following formula:
The receivables turnover ratio is most often calculated on an annual basis, though it can also be calculated on a quarterly or monthly basis.
Receivable turnover ratio is also often called accounts receivable turnover, the accounts receivable turnover ratio, or the debtor’s turnover ratio.
BREAKING DOWN 'Receivables Turnover Ratio'
In essence, the receivables turnover ratio indicates the efficiency with which a firm collects on the credit it issues to customers. Firms that maintain accounts receivables are indirectly extending interest-free loans to their clients since accounts receivable is money owed without interest. As such, because of the time value of money principle, a firm loses more money the longer it takes to collect on its credit sales.
To provide an example of how to calculate the receivables turnover ratio, suppose that during 2017 Company A had $800,000 in net credit sales. Also suppose that on the first of January it had $64,000 accounts receivable and that on December 31 it had $72,000 accounts receivable. With this information, one could calculate the receivables turnover ratio for 2017 in the following way:
average accounts receivable = ($64,000 + $72,000) / 2 = $68,000
receivables turnover ratio = $800,000 / $68,000 = 11.76
This means that Company A collects its receivables 11.76 times on average per year. This number also serves as an indicator of the number of accounts receivable a company collects during a year. One can determine the average duration of accounts receivable during a given year by dividing 365 by the receivables turnover ratio for that year. For this example, the average accounts receivable turnover is 365 / 11.76 = 31.04 days. The average customer takes 31 days to pay his or her bills. If the company had a 30-day policy for when payments should be made, then the average accounts receivable turnover shows that the average customer makes payments late.
Interpreting 'Receivables Turnover Ratio'
A high receivables turnover ratio can imply a variety of things about a company. It may suggest that a company operates on a cash basis, for example. It may also indicate that the company’s collection of accounts receivable is efficient, and that the company has a high proportion of quality customers that pay off their debts quickly. A high ratio can also suggest that the company has a conservative policy regarding its extension of credit. This can often be a good thing, as this filters out customers who may be more likely to take a long time in paying their debts. On the other hand, a company’s policy may be too conservative if it is too tight in extending credit, which can drive away potential customers and give business to competitors. In this case, a company may want to loosen policies to improve business, even though it may reduce its receivables turnover ratio.
A low ratio, in a similar way, can also suggest a few things about a company, such as that the company may have poor collecting processes, a bad credit policy or none at all, or bad customers or customers with financial difficulty. Theoretically, a low ratio can also often mean that the company has a high amount of cash receivables for collection from its various debtors, should it improve its collection processes. Generally, however, a low ratio implies that the company should reassess its credit policies in order to ensure the timely collection of imparted credit that is not earning interest for the firm.
Uses of 'Receivables Turnover Ratio'
The receivables turnover ratio has several important functions other than simply assessing whether or not a company has issues collecting on credit. Though this offers important insight, it does not tell the whole story. For example, if one were to track a company’s receivables turnover ratio over time, it would say much more about the company’s history with issuing and collecting on credit than a single value can. By looking at the progression, one can determine if the company’s receivables turnover ratio is trending in a certain direction or if there are certain recurring patterns. What is more, by tracking this ratio over time alongside earnings, one may be able to determine whether a company’s credit practices are helping or hurting the company’s bottom line.
While this ratio is useful for tracking a company’s accounts receivable turnover history over time, it may also be used to compare the accounts receivable turnover of multiple companies. If two companies are in the same industry and one has a much higher receivables turnover ratio than the other, it may prove to be the safer investment.
Limitations of 'Receivables Turnover Ratio'
Like any metric attempting to gauge the efficiency of a business, the receivables turnover ratio comes with a set of limitations that are important for any investor to consider before using it.
One important thing to consider is that companies will sometimes use total sales instead of net sales when calculating their ratio, which generally inflates the turnover ratio. While this is not always necessarily meant to be deliberately misleading, one should generally try to ascertain how a company calculates their ratio before accepting it at face value, or otherwise should calculate the ratio independently.
Another important consideration is that accounts receivable can vary dramatically over the course of the year. This means that if one picks a start and end point for calculating the receivables turnover ratio arbitrarily, the ratio may not reflect the true climate of the company’s issuing of and collection on credit. As such, the beginning and ending values selected when calculating the average accounts receivable should be carefully picked so as to represent the year well. In order to account for this, one could take an average of accounts receivable from each month during a twelve-month period.
It is also important to note that comparisons of different companies’ receivables turnover ratios should only be made when the companies are in the same industry, and ideally when they have similar business models and revenue numbers as well. Companies of different sizes may often have very different capital structures, which can greatly influence turnover calculations, and the same is often true of companies in different industries. The receivables turnover ratio is not particularly useful in comparing companies with significant differences in the proportion of sales that are credit, as determining the receivables turnover ratio of a company with a low proportion of credit sales does not indicate much about that company’s cash flow. Comparing such companies with those that have a high proportion of credit sales also does not usually indicate much of importance.
Lastly, a low receivables turnover ratio might not necessarily indicate that the company’s issuing of credit and collecting of debt is lacking. If, for example, distribution messes up and fails to get the right goods to customers, customers may not pay, which would also decrease the company’s receivables turnover ratio.
CREDITORS TURNOVER RATIO/ACCOUNTS PAYABLE TURNOVER RATIO
The accounts payable turnover ratio is a short-term liquidity measure used to quantify the rate at which a company pays off its suppliers. Accounts payable turnover ratio is calculated by taking the total purchases made from suppliers, or cost of sales, and dividing it by the average accounts payable amount during the same period.
BREAKING DOWN 'Accounts Payable Turnover Ratio'
The measure shows investors how many times per period the company pays its average payable amount. Accounts payable, also known as payables, represents short-term debt obligations that a company must pay off. The accounts payable is listed under a company's current liabilities on its balance sheet. Accounts payable are also part of households because people may be subject to pay off their short-term debt provided by creditors, such as credit card companies.
Interpretation
If the turnover ratio is falling from one period to another, this is a sign that the company is taking longer to pay off its suppliers than it was in previous time periods. The opposite is true when the turnover ratio is increasing, which means that the company is paying off suppliers at a faster rate.
Example
For example, if company A made $100 million in purchases from suppliers during the previous year, and at any given point it held an average accounts payable of $20 million, the accounts payable turnover ratio for the previous accounting period was 5, or $100 million / $20 million. Assume that during the current year, company A had cost of goods sold (COGS) of $120 million, accounts payable of $30 million for the start of the accounting period, and accounts payable of $50 million for the end of the period.
To calculate the average accounts payable for the fiscal year, sum the two accounts payable amounts, and divide by two. Therefore, the average accounts payable was $40 million, or ($30 million + $50 million) / 2, for the current year. Consequently, the accounts payable turnover ratio was 3, or $120 million / $40 million.
Assume that during the current year, company B, which is in the same industry as company A, had COGS of $110 million, accounts payable of $20 million for the end of the accounting period, and payables of $15 million for the start of the accounting period. This means that company B had an average accounts payable of $17.50 million, or ($15 million + $20 million) / 2. Company B had an accounts payable turnover ratio of 6.29, or $110 million / $17.50 million. Therefore, when compared to company A, company B is paying off its suppliers at a faster rate.
Read more: Accounts Payable Turnover Ratio https://www.investopedia.com/terms/a/accountspayableturnoverratio.asp#ixzz57Bf2Rx6c
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