Efficiency Ratios

Accounts receivable turnover ratio

The accounts receivable turnover ratio shows how quickly your credit customers are paying you. The greater the number of times receivables turn over during the year, the shorter the time between the sale and collecting the cash for that sale. It measures the effectiveness of your credit management policies with extending credit and collecting debts.

The formula used to calculate the accounts receivable turnover ratio is:

Accounts receivable turnover ratio  =  total sales ÷ accounts
                                                                      receivable

  • The higher the ratio, the faster your business collects its accounts receivables and the more cash it has available. Businesses that operate on a mainly cash basis will have a high ratio.
  • A low ratio indicates inefficient management of debtors or less liquid debtors. The business needs to re-assess its credit management procedures to ensure faster collection of debts.

Average collection period

The average collection period shows the average number of days it takes your business to collect payment for sales to customers on credit.

The formula used to calculate the average collection period is:

Average collection    =   365 ÷ (total sales ÷ accounts receivable)
       period                =   365 ÷ accounts receivable turnover ratio

The speed at which bills are collected has a significant impact on the cash flow of your business. Use this ratio to determine how long your business's money is being tied up in customer credit.

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Accounts payable turnover ratio

The accounts payable turnover ratio shows how quickly your business pays its bills and how often payables turn over during the year. Trends in the accounts payable turnover ratio demonstrates how your business handles its outgoing payments and can help you assess the cash situation of your business.

The formula used to calculate the accounts payable turnover ratio is:

Accounts payable    =   Cost of goods sold ÷ accounts payable
turnover ratio

Average payment period

The average payment period shows the average number of days it takes your business to make payment for purchases on credit.

The formula used to calculate the average collection period is:

Average payment = 365 ÷ (Cost of goods sold ÷ accounts payable)
        period          = 365 ÷ Accounts payable turnover ratio

  • A high ratio means there is a relatively short time period between purchasing inventory or materials and paying for them.
  • A low ratio may indicate that your business has a problem with cash shortages.

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Inventory turnover ratio

The inventory turnover ratio tells you the number of times your inventory turns over during the year. It indicates how quickly inventory is sold and replaced in the operating period.

You will first need to calculate the annual average value of inventory:

Annual average value =(opening inventory + closing inventory) ÷ 2
     of inventory

The formula used to calculate the inventory turnover ratio is:

Inventory turnover  =  Cost of goods sold ÷ annual average value
       ratio                                        of inventory

  • Generally, a high inventory turnover ratio is an indicator of high demand for your products and good inventory management.
  • However, a high ratio can also mean there is a shortage of inventory and your business is losing sales because of inadequate stock on hand.

A low inventory turnover ratio may indicate that inventory is naturally slow moving in your industry, or that you are carrying too much or obsolete inventory. Inventory that is turning over too slowly could hamper your cash flow, and your business will tend to require higher working capital.

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What's next…

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