Advantages and Disadvantages of Receivables Turnover Ratio

Receivable turnover ratio is the financial tool that use to measure the company ability to collect its account receivable. It evaluates the management strategy efficiency which helps them to convert accounts receivable to cash. The shorter it spend in collecting cash, the better it is. The company will have enough cash to pay for suppliers, employees, and other parties.

If the company spends a long time collecting money, they need to find other sources of cash to settle the current liabilities. The company needs to spend other costs to acquire those sources of funds. If they are not able to obtain other funds, it will be a problem. A serious problem can lead to the liquidation of the company.

Receivable Turnover Ratio Formula

\[Receivable\ Turnover\ Ratio = {Net\ Credit\ Sale \over Average\ Receivable}\]

\[Receivable\ Turnover\ in\ Days = {365 \over Receivable\ Turnover\ Ratio}\]

Advantage of Receivable Turnover Ratio

  • Access company main source of cash flow: Cash generated from sales is the main source of funds for the company. If most of the cash of company is stuck as receivable, it will be a problem. So management needs to keep an eye on this ratio.
  • Help to prepare the credit policy: It is one of the factors which will influence the company credit policy. When the ratio is too low, it means company spends more time collecting cash, so we can adjust the credit sale policy by decrease the credit term. On the other hand, if ratio is good, we can increase the credit term to increase the revenue and improve customers’ relationship.
  • Access company risk and find a solution: The ratio will tell us what will happen in the future. If it is getting worse, management needs to find other solutions to raise cash before it is too late.
  • Can be used as the KPI for staff and department: Management can use this ratio to set KPI for collecting department.

Disadvantage of Receivable Turnover Ratio

  • Seasonal business: The ratio is calculated at the end of the year it may not reflect the whole year’s performance.
  • Not suitable for cash sale business: It is not reasonable to calculate this ratio for businesses that use cash sales.
  • Can be a factor prevent company from increasing sale: Management may be addicted to the ratio and want to keep it in a good position. They will end up rejecting some purchases that demand a long credit terms.