How to Calculate Trade Receivables Turnover Ratio with Stepwise Example
The trade receivables turnover ratio is a key accounting metric that measures how efficiently a business collects cash from its credit customers. Understanding this concept is especially important for students preparing for Commerce exams, as well as for anyone aiming to assess a company's financial health and credit management strategies in real business scenarios.
| Term | Meaning | Formula |
|---|---|---|
| Trade Receivables | Amounts owed to a business by customers from credit sales | Debtors + Bills Receivable |
| Trade Receivables Turnover Ratio | Shows how many times a business collects its average receivables in a period | Net Credit Sales / Average Trade Receivables |
| Receivables Turnover in Days | Average number of days to collect receivables | 365 / Receivables Turnover Ratio |
Trade Receivables Turnover Ratio: Definition and Relevance
The trade receivables turnover ratio indicates how quickly a business converts its credit sales into cash. For students studying accountancy, especially in Class 12 or for competitive exams, it helps in understanding credit management and liquidity analysis. Businesses also use this ratio to track collection performance and maintain smooth cash flow.
Trade Receivables Turnover Ratio Formula
The formula for calculating the trade receivables turnover ratio is:
Trade Receivables Turnover Ratio = Net Credit Sales / Average Trade Receivables
- Net Credit Sales = Total Credit Sales - Sales Returns
- Average Trade Receivables = (Opening Receivables + Closing Receivables) / 2
Steps to Calculate Trade Receivables Turnover Ratio
- Find Net Credit Sales for the period.
- Compute Average Trade Receivables (Debtors + Bills Receivable average).
- Divide Net Credit Sales by Average Trade Receivables.
Interpretation of Trade Receivables Turnover Ratio
A high trade receivables turnover ratio means the company collects its debts quickly, reflecting effective credit policy and strong liquidity. A low ratio suggests potential problems in collection or lenient credit terms, which can lead to cash flow issues. The ideal ratio can vary by industry.
| Scenario | Ratio Value | Interpretation |
|---|---|---|
| High Ratio | > Industry Average | Efficient collection, strict credit policy |
| Low Ratio | < Industry Average | Slow collection, weak credit policy, possible cash issues |
Example: Trade Receivables Turnover Ratio Calculation
- Suppose Net Credit Sales in the year = ₹4,00,000.
- Opening Trade Receivables = ₹50,000; Closing Trade Receivables = ₹70,000.
- Average Trade Receivables = (₹50,000 + ₹70,000) / 2 = ₹60,000.
- Trade Receivables Turnover Ratio = 4,00,000 / 60,000 = 6.67 times.
This means the company collects its average receivables about 6.67 times per year.
Importance of Trade Receivables Turnover Ratio in Accounting
- Helps businesses assess the effectiveness of their credit policy.
- Assists in monitoring cash flow and liquidity.
- Enables early detection of slow-paying customers.
- Essential for ratio analysis in exams and business decisions.
- Acts as a key metric in working capital management.
Receivables Turnover Ratio in Days
Receivables turnover in days tells how many days, on average, it takes to collect receivables.
Formula:
Receivables Turnover in Days = 365 / Trade Receivables Turnover Ratio
If the ratio above is 6.67, then:
365 / 6.67 ≈ 55 days
This means, on average, it takes 55 days to collect each credit sale.
Comparison: Receivables vs Payables and Asset Turnover Ratios
| Ratio | What It Measures | Formula |
|---|---|---|
| Trade Receivables Turnover Ratio | Speed of collecting amounts from customers | Net Credit Sales / Avg. Trade Receivables |
| Trade Payables Turnover Ratio | Speed of paying suppliers | Net Credit Purchases / Avg. Trade Payables |
| Asset Turnover Ratio | Efficient use of total assets to generate sales | Net Sales / Average Total Assets |
Limitations of the Trade Receivables Turnover Ratio
- May not reflect seasonal changes in sales or collections.
- Industry standards vary; comparison can be misleading.
- Can be affected by changes in credit policy mid-year.
- Does not show the quality of receivables or potential bad debts.
- Single ratio analysis does not provide a complete financial picture.
The trade receivables turnover ratio is vital for students preparing for accountancy exams and for understanding practical business collection practices. Remember, you can master this concept for exams or real-life company analysis by practicing with more examples. For more on related ratios, check out Accounting Ratios and Analysis of Financial Statements at Vedantu.
In summary, the trade receivables turnover ratio measures how efficiently companies collect from credit customers. It is calculated as Net Credit Sales divided by Average Trade Receivables, and is essential for assessing credit management, liquidity, and collection efficiency for exams and daily business use.
FAQs on Trade Receivables Turnover Ratio Explained for Students
1. What is the trade receivables turnover ratio?
The trade receivables turnover ratio measures how efficiently a business collects payments from its credit sales. A higher ratio indicates faster collection and better credit management.
2. How do you calculate the trade receivables turnover ratio formula?
The trade receivables turnover ratio is calculated as: Net Credit Sales / Average Trade Receivables. This shows how many times, on average, a company collects its receivables during a period.
3. What does a high or low trade receivables turnover ratio mean?
A high ratio suggests efficient debt collection and strong credit control. A low ratio may indicate slow payments, potential bad debts, or less efficient credit management. The ideal ratio varies by industry.
4. How is the trade receivables turnover ratio used in Class 12 exams?
The trade receivables turnover ratio is a key concept in Class 12 Accountancy. Exam questions often involve calculating the ratio, interpreting its meaning, and comparing it to industry benchmarks. Understanding its implications for liquidity and working capital is crucial.
5. How to calculate trade receivables turnover ratio in days?
To calculate the receivables turnover ratio in days (also known as the Days Sales Outstanding or DSO), use the formula: (Average Trade Receivables / Net Credit Sales) * Number of Days in the Period. This indicates the average number of days it takes to collect receivables.
6. What is the difference between trade receivables and accounts receivables?
While often used interchangeably, trade receivables specifically refer to amounts owed to a business from customers for credit sales. Accounts receivables is a broader term encompassing all amounts owed to a business, including those from sources other than credit sales.
7. How do you calculate trade payable turnover ratio?
The trade payable turnover ratio measures how quickly a business pays its suppliers. It's calculated as: Net Credit Purchases / Average Trade Payables. A higher ratio suggests faster payment of debts.
8. What is a good AR turnover?
A 'good' accounts receivable (AR) turnover ratio varies depending on the industry and the company's credit policy. Generally, a higher ratio (indicating faster collections) is preferred, but excessively high ratios may suggest overly restrictive credit terms.
9. What is a good AR/days ratio?
A good AR/days ratio (Days Sales Outstanding or DSO) also depends on industry norms. A lower DSO indicates faster collection of receivables, while a higher DSO suggests slower collections and potential cash flow issues. Benchmarking against competitors is essential.
10. How are trade receivables calculated?
Trade receivables are calculated by summing up all outstanding amounts owed to a business from customers for credit sales at a specific point in time. This information is typically found on a company's balance sheet.
11. What is the average accounts receivable formula?
The average accounts receivable is calculated by adding the beginning and ending accounts receivable balances for a period and dividing by two: (Beginning Receivables + Ending Receivables) / 2. This provides an average figure used in various accounting ratios.
