2. Activity: Accounts Receivable

RECEIVABLES TURNOVER

Receivables turnover indicates how many times (per year) a firm collects its accounts receivables, on average. The ratio therefore measures the firm's efficiency to issue credit to its customers and to collect funds from them. 

  • A high receivables turnover ratio indicates that the capital  tied up in accounts receivables is liquid. This could be the result of a conservative credit policy (only solvent clients can buy on credit) or an aggressive collection department. 
  • A low receivables turnover ratio, in contrast, implies that the firm is not very good at converting accounts receivable into cash. This could be because a substantial part of the clients is in financial difficulties or because the collection department is not very aggressive. 

The most common measure of receivables turnover divides net sales during a specific period by the average value of accounts receivable during that period:
 

Receivables turnover = \( \frac{\text{Net sales}}{\text{Average accounts receivable}} \).

 

To illustrate the ratio, let's look again at Hershey in 2015. From its balance sheets and income statement we know (in millions of USD):

  • Net sales 2015: 7'386.6
  • Accounts receivable beginning of 2015 (end of 2014): 596.9
  • Accounts receivable end of 2015: 599.1

The numbers imply that Hershey's average receivables during 2015 were 598.0:

 

Average receivables = \( \frac{\text{Accounts receivable}_{2014} + \text{Accounts receivable}_{2015} }{2} = \frac{596.9+599.1}{2} \)= 598.0.

 

Hence, the firm's receivables turnover was 12.35:

  

Receivables turnover = \( \frac{\text{Net sales}}{\text{Average accounts receivable}} = \frac{7'386.6}{598} \) = 12.35.

  

Put differently, the firm manages to collect its average accounts receivables 12.35 times per year.

For many analysts, a more intuitive way is to translate this turnover frequency into a turnover time. This will yield the so-called average collection period.

 

AVERAGE COLLECTION PERIOD

The average collectio period (often also called Days Sales Outstanding, DSO) indicates the number of days the customers take, on average, to pay for their credit purchases. The longer the average collection period, the larger the amount of money that is tied in a relatively unproductive asset. 

Formally, DSO is computed as follows:

  

DSO = \( \frac{\text{Average accounts receivable}}{\text{Net sales}} \times 365 \).

  

Alternatively, we find DSO by dividing 365 by the firm's receivable turnover: 

 

DSO = \( \frac{365}{\text{Receivables turnover}} \).

 

In the case of Hershey, we found a receivables turnover of 12.35. Assuming a year has 365 days, this means that it takes Hershey, on average, 29.6 days to collect the money from their customers:

 

DSO = \( \frac{365}{\text{Receivables turnover}} = \frac{365}{12.35} \)= 29.6 days.


Assuming that a substantial part of the firm's sales are actually for credit, a DSO of less than 30 days indicates that the firm has a fairly efficient collection department.

Now suppose that Hershey wanted to accelerate its DSO to 20 days to free capital that is tied up in accounts receivables. How much capital could the firm free with this policy change (assuming that net sales remain unaffected)?

To find an answer, we can go back to the orignial equation for DSO and solve it for Average accounts receivable: 

 

Average accounts receivable = \( \frac{\text{Net sales}}{365}\times DSO \). 

 

Consequently, average accounts receivable would drop form 598 million to 405 million: 

 

Average accounts receivable = \( \frac{7'386.6}{365}\times 20 \) = 405 million.

 

By accelerating its credit terms, Hershey could, therefore, free 193 million [= 598 - 405].