Accounts receivable refers to the money owed to a business for goods or services acquired by a customer via credit. Accounts receivable are considered to be current assets of a business, continually converting to cash as the customers pay their bills. In comparison, the revenue ratio is the ratio of a company’s net credit sales compared to its average amount of accounts receivable, which is also referred to as the accounts receivable turnover ratio.
Accounts Receivable Basics
Accounts receivable are created when an individual or corporate customer has made a purchase from your company but has not yet paid you any money. It is a typical mode of operation for most companies. Companies usually extend an operating line of credit to their recurrent customers, and when the customers make a purchase using their credit, the money owed is generally due within a short period of time, often 10 to 90 days. Your accounts receivable refers to the total amount customers owe your company, and it is part of determining the value of your business.
AR to Sales Ratio
The average length of time it takes for your company to collect accounts receivable, or how long it takes customers to pay their bills, is your revenue ratio or accounts receivable turnover ratio. The ratio indicates how many times credit sales are converted to cash during an accounting period. The revenue ratio is calculated by dividing the total amount of credit sales for the period by the average amount of outstanding accounts receivable. For example, if credit sales totaled $600,000, and at the start of the year the accounts receivable balance was $70,000, and at the end of the year it was $65,000, the average receivable balance was $67,500 ($70,000 + $65,000 / 2). To calculate the revenue or turnover ratio, divide $600,000 by $67,500 to arrive at 9 (8.89), indicating your accounts receivable were converted to cash approximately nine times throughout the year.
The Ins and Outs of Liquidity
The accounts receivable turnover ratio is also a sign of your company’s liquidity or quantity of cash assets. When the ratio is higher, your company is more liquid, indicating your company’s management team is effective in granting credit to customers and collecting in a timely manner. The revenue ratio paints a picture of the credit risk your company may present to investors or lenders, because it reveals your business’s ability or inability to meet its short-term financial obligations or debts due within one year.
Relationship to Other Financial Ratios
A number of financial ratios can be effective tools for determining your company’s overall performance and financial position. Besides the revenue ratio, or accounts receivable turnover ratio, other useful ratios include liquidity ratios, inventory turnover ratios, financial leverage ratios, dividend policy ratios and profitability ratios. Financial ratios are categorized by the information they supply about a company’s fiscal activities.
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- Net MBA: Financial Ratios
- Financial Terms: Accounts Receivable Days (A/R Days)
- CPA Class: Accounting Ratios for Financial Statement Analysis
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Based in California, Debbie Donner is a freelance online writer who primarily writes articles related to personal finance. Donner received a Mensa scholarship in 2006 while attending California State University, Fresno. She holds a Bachelor of Arts degree in liberal arts and a multiple-subject teaching credential.