Ratio Analysis: Evaluating A/R Management

How do we know if a company is doing a good job managing their A/R? Great question! It is crucial that A/R is collected as soon as possible. After all, we know that the longer an A/R balance remains uncollected, the less likely the balance will be collected. So how do we evaluate whether management is doing a good job collecting on their receivables? Let’s calculate how many days, on average, it takes a company to collect their receivables. We’ll do this in two steps:

Calculate A/R TurnoverA/R Turnover:
Describes how many times the entire accounts receivable (A/R) balance was collected during the fiscal year and is calculated as credit sales divided by the average A/R balance during the year. See also: Days in A/R..

This ratio calculates how many times the entire A/R balance was collected during the fiscal year and is calculated as Sales divided by the average A/R balance during the year (A/R beginning + A/R ending, divided by two).

   

This ratio is a bit abstract, so let’s instead ask: how many days does it take the company to collect their receivables?

Calculate Days in A/RDays in A/R:
An efficiency ratio interpreted as the average number of days that an amount remains in A/R before being received by customers. Calculated as 365 divided by A/R turnover. Also called average days in A/R. See also: A/R turnover.

by dividing 365 days by A/R Turnover.

   

Let’s try using an example.

My turn:

Miles Motors reports the following information relating to A/R:

A/R (20X1)	25,800
A/R (20X2)	15,500
Sales	720,000

Miles’ biggest competitor reports Average Days in A/R of 13 days.

Required:

What is Miles’ A/R Turnover and days in A/R for the fiscal year ended in 20X2? Is Miles’ A/R management better or worse than their competitor?

A/R Turnover:

Average Days in A/R:

Miles is outperforming his competitor in collecting outstanding A/R by 3 days on average (10 days – 13 days)

It’s your turn. Try calculating turnover and days in A/R ratios in this example:

Great work! You now know the basics of Accounts Receivable. You know that:

• A/R (gross) is the amount that customers owe,
• Allowance for Doubtful Accounts is the amount the company estimates is uncollectible based on company collection history, and
• A/R (net) is the amount expected to be collected from customers for sales on account.

You also know how to calculate uncollectible amounts, how to change the balance of Allowance for Doubtful Accounts to its calculated ending balance, how to write off accounts, and how to reinstate accounts if a company receives unexpected payments. Lastly, you learned how to evaluate a company’s receivable management using A/R turnover and Average Days in A/R.

The next chapter will focus on Inventory. I’ll see you on our next adventure through the asset section of the Statement of Financial Position!