The balance of a company’s accounts receivable account shows the amount its customers owe for purchases they made on credit. A company wants to collect as much of the balance as possible and as quickly as possible to generate incoming cash flow. You can calculate a company’s accounts receivable turnover ratio to measure the quality and the liquidity of its accounts receivable. Liquidity means the ability to turn an asset into cash. The ratio shows how many times the company's accounts receivable balance “turned over,” or was collected, during an accounting period. A higher ratio signals higher quality and liquidity of accounts receivable.
Find a company’s accounts receivable balance listed on its most recent year’s balance sheet and its prior year’s balance sheet. For example, assume the company had an accounts receivable balance of $1 million at the end of the most recent year and a $3 million balance at the end of the prior year.
Add the two balances together. Then divide by 2 to calculate the average accounts receivable balance the company held during the most recent year. You must calculate the average balance held during the year because the balance sheet reports account balances only at the end of the year. For example, add $1 million to $3 million, which equals $4 million. Divide this by 2, which equals a $2 million average accounts receivable balance.
Find a company’s net sales listed on its most recent year’s income statement. For example, assume the company had $30 million in net sales during the year.
Divide the company’s net sales by its average accounts receivable balance to calculate its accounts receivable turnover ratio. For example, divide $30 million in net sales by $2 million in average accounts receivable, which equals an accounts receivable turnover ratio of 15. This means the company collected its accounts receivable balance approximately 15 times during the most recent year.
Compare the company’s accounts receivable turnover ratio with its ratio in previous years and with the ratios of its competitors. An increasing ratio over time suggests the quality of its accounts receivable is improving and the company is collecting the balance faster, while a decreasing ratio suggests it may be having trouble collecting its accounts receivable balance. A ratio that is higher than its competitors' suggests it may be managing its collections more efficiently.
You can substitute net credit sales for net sales in the accounts receivable turnover ratio calculation if you can obtain that figure, but most companies do not report net credit sales.