Total asset turnover ratio11/28/2023 ![]() ![]() ![]() Tighter credit terms may attract fewer customers but may also reduce bad debt expense. Loose credit terms may attract more customers but may also increase bad debt expense. It’s key to note the tradeoff in adjusting credit terms. The determination of a high or low turnover rate really depends on the standards of the company’s industry. The lower turnover rate may signal a high level of bad debt accounts. The lower turnover also shows that the company has cash tied up in receivables longer, thus hindering its ability to reinvest this cash in other current projects. A slower collection rate could signal that lending terms are too lenient management might consider tightening lending opportunities and more aggressively pursuing payment from its customers. In contrast, a lower number of times indicates that receivables are collected at a slower rate. Excluding these customers means that they may take their business to a competitor, thus reducing potential sales. The higher number of times may also be a negative occurrence, signaling that credit extension terms are too tight, and it may exclude qualified consumers from purchasing. This quick cash collection may be viewed as a positive occurrence because liquidity improves, and the company may reinvest in its business sooner when the value of the dollar has more buying power (time value of money). A higher number of times indicates that receivables are collected quickly. One receivables ratio is called the accounts receivable turnover ratio.This ratio determines how many times (i.e., how often) accounts receivable are collected during a year and converted to cash. Receivables ratios show company performance in relation to current receivables (what is due from customers), as well as credit policy effect on sales growth. Let’s take a look at the accounts receivable turnover ratio, which helps assess that element of the cash conversion cycle. In this example, Clear Lake’s cash cycle is 75 days. This company did not pay for its lures until August 15 when it settled its account. Referring to Clear Lake’s June 1 shipment of lures that sold by July 15, assume that some of the customers were fishing guides that keep an open account with Clear Lake. Accounts receivable is one section of that cycle. The cash conversion cycle is the time it takes to spend cash to purchase inventory, produce the product, sell it, and then collect cash from the customer. Cash Conversion CycleĬash, however, doesn’t necessarily flow linearly with accounting periods or operating cycles. In this example, Clear Lake’s operating cycle is 45 days. By July 15, all the lures from that shipment are gone. It stocks the shelves with lures and tracks its inventory and sales. For example, assume Clear Lake Sporting Goods orders and receives a shipment of fishing lures on June 1. Essentially it is the time it takes a business to purchase or make inventory and then sell it. The operating cycle includes the cash conversion cycle plus the accounts receivable cycle (discussed below). Operating CycleĪ period is one operating cycle of a business. To begin an analysis of receivables, it’s important to first understand the cycles and periods used in the calculations. Figure 6.2 shows the comparative income statements and balance sheets for the past two years.įigure 6.2 Comparative Income Statements and Year-End Balance Sheets Note that the comparative income statements and balance sheets have been simplified here and do not fully reflect all possible company accounts. Clear Lake Sporting Goods is a small merchandising company (a company that buys finished goods and sells them to consumers) that sells hunting and fishing gear. Accounts Receivable Turnoverįor our discussion of financial statement analysis, we will look at Clear Lake Sporting Goods. ![]() Let’s examine four efficiency ratios: accounts receivable turnover, total asset turnover, inventory turnover, and days’ sales in inventory. A company that is efficient will usually be able to generate revenues quickly using the assets it has acquired. Important areas of efficiency are the management of sales, accounts receivable, and inventory. Assess organizational performance using days’ sales in inventory calculations.Įfficiency ratios show how well a company uses and manages its assets, one key element of financial health.Evaluate management’s use of assets using total asset turnover and inventory turnover.Calculate accounts receivable turnover to assess a firm’s performance in managing customer receivables.By the end of this section, you will be able to: ![]()
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