Accounts Receivable is the total amount of money owed to your business by your customers from sales on account. AR is considered an asset of your business, as it represents an amount of cash you will collect at some future date. However, the AR balance tells creditors and investors very little about your business. To use the information, they will want to know accounts receivable turnover, or how often you are collecting the value of your accounts receivable. To calculate AR turnover, you need to start by finding average accounts receivable.
Average Receivables Formula
The average accounts receivable formula is found by adding several data points of AR balance and dividing by the number of data points. Some businesses may use the AR balance at the end of the year, and the AR balance at the end of the prior year. This method is easiest because the figures needed are readily available in the year-end balance sheets.and result in average accounts receivable that reflects only the typical balance on that one day of the year. If you have a business with seasonal fluctuations, this is not going to give a real picture of what your balance is throughout the year.
Another method is to use the balances from the end of each of the past 13 months. These figures can still be found on month-end balance sheets, so it is nearly as easy to use. It merely uses 13 data points instead of 2. This method reflects seasonal differences better, and the inclusion of thirteenth-prior month also indicates year-to-year differences.
How to Calculate Average Accounts Receivable Examples
Primo Pet Supplies Company has the following balances in their accounts receivable, according to their balance sheets:
December 31, 2016 - $40,000
January 31, 2017 - $42,000
February 28, 2017 - $ 54,000
March 31, 2017 - $ 38,000
April 30, 2017 - $40,000
May 31, 2017 - $45,000
June 30, 2017 - $41,000
July 31, 2017 - $ 61,000
August 31, 2017 - $59,000
September 30, 2017 - $44,000
October 31, 2017 - $48,000
November 30, 2017 - $42,000
December 31, 2017 - $44,000
If you use the first method, where we average the two year-end figures, the average accounts receivable would be $42,000. You would add the two December figures, $40,000 plus $44,000, to get $84,000. You would then divide that by 2, since that is how many data points you used, to get the $42,000 figure.
If you calculate instead by the 13-month average, you will add up all the figures, which gives you $598,000. You divide that by the number of data points which is 13 and gives you average accounts receivable of $46,000. Comparing the two figures, you can see that using 13 months gave you a higher number, which more accurately considers the higher months like July and August.
Calculating the Accounts Receivable Turnover Ratio
Average accounts receivable gives you some information, but not much. It shows the company is making sales, which is great. But is the company collecting on those sales, or are they giving goods or services away for free? The accounts receivable turnover ratio helps you examine how many times you are collecting AR, thus turning receivables into cash. The formula for the accounts receivable turnover ratio is net credit sales divided by average accounts receivable. Cash sales are left out because they do not affect receivables. Generally, you can find a company's credit sales on their income statement.
For the year 2017, Primo Pet Supplies Company had $400,000 in credit sales. From the previous example, Primo's average accounts receivable was $46,000. If we divide $400,000 by $46,000, we see that Primo has AR turnover of 8.7. This means that Primo collects nearly their entire AR balance at least eight times per year and that it is taking about one-and-a-half months or about 45 days after a sale is made to collect the cash. Not only is this important information for creditors, but it also helps the business more accurately plan its cash flow needs. It also allows the business to examine whether or not their credit policies are too restrictive or too generous.
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