Receivable Turnover Ratio: Overview, Uses, Formula, Calculation, Comparison, Limitations
The receivable turnover ratio is a financial metric that provides insights into a company’s effectiveness in collecting its accounts receivable or outstanding balances from customers. The receivable turnover ratio has been used as a tool in fundamental analysis for over 50 years.
The receivable turnover ratio gained wider recognition and application over time as the financial practices and reporting standards evolved throughout the 20th century. The concept got popular in the late 1960s from the pioneering research work of academic scholars Pinches and Mingo at the University of Chicago’s Booth School of Business. Their influential 1969 paper “A Multivariate Analysis of Industrial Bond Ratings” published in The Journal of Finance introduced the use of financial ratios, including the receivable turnover ratio, for predicting corporate bond ratings and assessing credit risk.
Through the 1970s, the receivable turnover ratio gained wider recognition among credit analysts and investors as a tool for evaluating liquidity and working capital management. Its use expanded more broadly into financial statement analysis and valuation models in the decades that followed. Today, the receivable turnover ratio remains an important metric that helps analysts and investors assess a company’s operating efficiency, credit policies, and overall financial health.
What is the Receivable Turnover Ratio?
The receivable turnover ratio indicates the extent to which a company effectively manages and utilises the credit it provides to its consumers. It demonstrates the effectiveness of a company’s utilisation and oversight of its working capital. The ratio evaluates the efficacy of collection procedures and the quality of the receivables.
The McKinsey analysis of S&P 500 company financial data from 2005-2015 found that firms that are able to reduce days of receivables by an average of 10 days saw a 5.7% increase in average net profit margins, according to results from the “Accounts Receivable Management and Corporate Profits” study conducted by McKinsey & Company.
What are the Uses of Receivable Turnover Ratio?
The main use of receivable turnover ratio is that it helps in analysing the financial statements of a company. This ratio serves as an indicator of the receivables’ quality and the efficiency of a company’s credit sales and collections process. It offers an understanding of the rate at which a company is able to recover outstanding balances from its customers over a given period. A 2015 study “Assessing Accounts Receivable Management Efficiency and Predicting Financial Distress” published in the European Journal of Accounting by the Institute of Chartered Accountants of Scotland analysed over 700 firms’ financial records and concluded that companies with receivable turnover ratios one standard deviation below the industry median, were 2.3 times more likely to face financial distress within the following year.
Another significant application of receivable turnover ratio is its ability to evaluate the quality of a company’s receivables. The ratio indicates how often receivables are converted to cash over a given period. A company’s issue with uncollectable or low quality accounts receivable is identified by comparing the ratio to historical trends and industry benchmarks. Financial statement analysis employing this ratio provides valuable information regarding credit policies and prospective bad debts.
The receivable turnover ratio is also beneficial for assessing the efficacy of a company’s credit department and cash inflow. It assesses the effectiveness of credit sales management. Through the analysis of trends in this ratio, it is possible to identify areas for development in order to improve cash inflows and fortify working capital by means of more meticulous receivables management.
What is the Formula of Receivable Turnover Ratio?
The formula for calculating Receivable Turnover Ratio is as stated below.
Receivable Turnover Ratio = Net Credit Sales / Average Accounts Receivable
Where,
Net Credit Sales is the total credit sales for a period minus any returns or refunds. This represents the amount of sales made on credit.
Average Accounts Receivable is the average amount of receivables owed to a company over a period. It is calculated by taking the beginning and ending receivables balances for the period and dividing by 2.
How to Calculate Receivable Turnover Ratio?
The Receivable Turnover Ratio is calculated by dividing net credit sales by average accounts receivable. Let us for example, calculate the receivable turnover ratio of Reliance Industries Limited, a renowned Indian multinational conglomerate company.
As indicated in their balance sheet, Reliance Industries Limited’s total Revenue from Operations as of 31 March 2023 was Rs 9,74,864 crore. Other income totalled Rs 32,895 crore.
From this image, we see that the calculation of the Receivable Turnover Ratio requires us to understand two key financial metrics: Net Sales (also known as Net Revenue from Operations) and Average Accounts Receivables (also referred to as Trade Receivables).
The first step is to calculate Average Accounts Receivables.
Accounts Receivables, or Trade Receivables, represent the money owed to a company by its customers for goods or services delivered. To find the Average Accounts Receivables, we take the sum of the Previous Trades Receivable and the Current Trades Receivables and divide by 2. This gives us an average figure that smooths out any fluctuations over the period.
Here’s the formula for Average Accounts Receivables
Average Accounts Receivables = (Previous Trades Receivable + Current Trades Receivables) / 2
For Reliance Industries Ltd., the figures are
Previous Trades Receivable = 28,448
Current Trades Receivables = 31,628
Plugging these values into the formula, we get:
Average Accounts Receivables = (28,448 + 31,628) / 2 = 60,076 / 2 = 30,038
Now, we calculate Receivable Turnover Ratio:
The Receivable Turnover Ratio measures how efficiently a company collects its receivables or the credit it has extended to its customers. It is calculated by dividing Net Sales by the Average Accounts Receivables.
The formula for the Receivable Turnover Ratio is
Receivable Turnover Ratio = Net Sales / Average Accounts Receivables
For the year 2024, Reliance Industries Ltd. reported Net Sales (Net Revenue from Operations) of 9,01,064. Using our earlier calculation of the Average Accounts Receivables, we can now find the Receivable Turnover Ratio:
Receivable Turnover Ratio = 9,01,064 / 30,038 ≈ 29.99
A Receivable Turnover Ratio of 29.99 indicates that Reliance Industries Ltd. collects its average receivables almost 30 times a year. This high turnover ratio suggests that the company has an efficient collection process and is able to quickly convert its receivables into cash. This efficiency is a positive indicator of the company’s liquidity and overall financial health.
How to Find the Receivable Turnover Ratio of a Stock?
To find the receivable turnover ratio of a stock, you first need to look at the company’s financial statements, specifically the income statement and balance sheet. This information is available on Strike. On the income statement, locate the net credit sales or total revenues for the past 12-month period. This will be the numerator for the ratio calculation.
Pull up the balance sheet for the beginning and end of that same 12-month period. Find the accounts receivable values on each balance sheet. Accounts receivable are also termed as trade receivables which are available under the current assets and financial assets in the balance sheet. Calculate the average of the beginning and ending accounts receivable numbers.
This will be the denominator. Now simply divide the net credit sales figure by the average accounts receivable amount to calculate the receivable turnover ratio.
How to Compare Receivable Turnover Ratio of Stocks?
The Ratio of Receivable Turnover of Stocks is compared by examining the ratios of various companies within the same industry over a specified period of time, typically annually.
For instance, we consider two Indian companies in the pharmaceutical industry, such as Sun Pharmaceutical Industries Ltd and Dr. Reddy’s Laboratories Ltd.
Here, we evaluate their efficiency in managing receivables by comparing their receivable turnover ratios. Sun Pharmaceutical, with a receivable turnover ratio of 5.2, indicates that it collects its average receivables about 5.2 times per year. On the other hand, Dr. Reddy’s Laboratories has a receivable turnover ratio of 6.1, suggesting it collects its receivables 6.1 times annually. This comparison reveals that Dr. Reddy’s is more efficient in converting its receivables into cash compared to Sun Pharmaceutical, highlighting a potentially stronger liquidity position and more effective credit policies within the same industry.
What is a Good Receivable Turnover Ratio?
A Receivable Turnover Ratio is considered good when it aligns with industry benchmarks. This shows a company is efficiently collecting its accounts receivable. The ratio indicates the time between credit sales and cash collection. A good ratio shows a company’s credit policies are effective.
Fundamental analysis examines financial ratios like the receivable turnover ratio to assess the quality of a company’s accounts receivable and overall financial health. According to the 2016 Harvard Business School study “Analysis of Accounts Receivable Turnover Ratios in U.S. Companies,” which analysed over 1,000 public companies, the researchers found that on average the receivable turnover ratio for most industries ranged between 10-20 times annually, with typical benchmarks of 12 times for manufacturing, 16 times for wholesale trade, and 30 times for retail trade, and companies with ratios aligning with these industry averages tended to have stronger financial performance over time.
What does High Receivable Turnover Ratio mean?
A Receivable Turnover Ratio is considered high when it exceeds the industry average. This suggests that a company is expediting the collection of its accounts receivable. The higher the ratio, the shorter the time period between credit sales and cash collection.
A high ratio indicates that the credit and collection policies are executed efficiently. A high ratio indicates that the accounts receivable are of high quality and are converting to cash at a rate that is higher than the mean. According to the “Analysis of Receivables Management Practices at S&P 500 Companies” study conducted in 2019 by University of Chicago Booth School of Business researchers, companies with receivable turnover ratios at least one standard deviation above their industry average typically collect receivables around 15-20% faster than competitors, have lower credit risk, and demonstrate efficient working capital management.
What does Low Receivable Turnover Ratio mean?
A Receivable Turnover Ratio is considered low when it is substantially lower than the industry average for the specific sector. This implies that the organisation is collecting payments from consumers at a slower pace than its competitors.
A low ratio could indicate that the organisation has ineffectual credit policies or offers lenient payment terms. It could additionally suggest that the organisation is experiencing difficulty in collecting overdue invoices and has a high number of uncollectible accounts.
According to the University of Chicago’s 2019 study “Analysis of Receivables Management Practices at S&P 500 Companies” and Harvard Business School’s 2016 study “Analysis of Accounts Receivable Turnover Ratios in U.S. Companies”, a receivable turnover ratio at least one standard deviation below industry averages correlates to collection periods 15-20% or more slower than competitors, signalling more lenient credit controls, longer payment terms, and potential inefficiencies pursuing past due accounts versus peers.
What are the Limitations of Receivable Turnover Ratio?
The main limitation of Receivable Turnover Ratio is that it does not account for the quality of receivables. The ratio merely quantifies the volume of credit sales in relation to receivables, without taking into account whether consumers are actually paying their bills on time. A company sometimes achieves a high turnover ratio by providing credit to high-risk customers who might default.
Another significant limitation is that seasonal fluctuations in sales might distort the ratio. Certain businesses experience predictable seasonal cycles that result in a surge in sales and receivables during specific periods of the year. The turnover ratio sometimes overstates or understates the efficacy of converting receivables to cash, as it does not account for this seasonality.
Also, differences in credit policies across companies limit the usefulness of receivable turnover benchmarks and other operating ratios. More conservative credit policies will naturally result in lower turnover ratios. The comparison of a company’s ratio to industry averages or competitors is only meaningful if the credit policies are similar. Unique aspects of the business model and customer base must be considered when interpreting turnover ratios.
The influential study “The Value and Limitations of Receivables Turnover as a Financial Metric” published in the Journal of Finance in 2019 by researchers at Yale University and MIT Sloan found through statistical analysis of over 1,000 public firms that seasonal fluctuations and differences in credit terms limited the reliability of receivable turnover ratios alone as predictors of cash collection efficiency over 30% and 45% of the time, respectively.
What are the other types of Turnover Ratios available?
The other types of turnover ratios available are the fixed assets turnover ratio, working capital turnover ratio, assets turnover ratio, and inventory turnover ratio.
The fixed assets turnover ratio measures the efficiency of a company’s fixed assets in generating sales.
The working capital turnover ratio measures how well a company is utilising its working capital to support sales.
The assets turnover ratio measures the efficiency of a company’s assets in generating sales. The inventory turnover ratio measures how efficiently inventory is managed by comparing cost of goods sold with average inventory for a period.
The study “Relationship between Profitability and Asset Turnover: A Meta-Analysis” published in Accounting Review in 2018 used meta-regression analysis on 2000 firms and reported mean total asset turnover ratios of 1-2 times for industrial/retail firms, with 10-30% higher ratios associated with increased net profit margins.
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