Accounting: what is turnover???

College Majors Business Majors
1

<p>Hey guys, I’m an accounting major right now and I’m studying the chapter on financial ratios (my class isn’t on that chapter yet, but I really like accounting and wanted to get ahead). Well I’m having a difficult time understanding turnover (accounts receivable turnover and inventory turnover).</p>

<p>I mean I know how to compute the ratios, that’s simple. I just don’t know what the ratios mean (and I know in accounting, knowing formulas isn’t enough, and that you have to really understand the material). So if net credit sales for the year are $480,000, and average accounts receivable is $40,000, then accounts receivable turnover is 12, correct? I just don’t know what this 12 means. I know 12 or greater is desirable and I know that has something to do with there being 12 months in a year but…idk, I guess I just can’t put everything together.</p>

<p>The accounting definitions of turnover that I’ve found on the internet all say that it means how often an asset is replaced during the year (or something like that). This just doesn’t make much sense to me. Accountingcoach.com is usually a lot of help, but not in this case</p>

<p>When explaining this concept to me, please explain it in as clear and concise of a manner as possible. Please explain it as though you are talking to someone who has no knowledge of accounting (even though this isn’t the case in reality). Yea I’m kind of a moron when it comes to certain things so certain concepts really have to be explained very carefully haha</p>

<p>Any help is appreciated, thanks!</p>

2

<p>[Receivables</a> Turnover Ratio](<a href=“http://www.investopedia.com/terms/r/receivableturnoverratio.asp]Receivables”>Receivables Turnover Ratio Defined: Formula, Importance, Examples, Limitations)</p>

<p>Now you could have done this yourself.</p>

3

<p>no I mean I already knew most of that, I just…ughhhh I can’t really explain what I mean. I’m just kind of having trouble putting 2 and 2 together.</p>

<p>I’ve been all over the internet looking for answers, I’ve even been to that site already as well, I just need someone here to explain it clearly and concisely if possible</p>

<p>Sorry that I’m a moron haha…I know this isn’t rocket science, I’m just having trouble understanding what it means for some strange reason</p>

4

<p>From the link above:</p>

<p>"A high ratio implies either that a company operates on a cash basis or that its extension of credit and collection of accounts receivable is efficient. </p>

<p>A low ratio implies the company should re-assess its credit policies in order to ensure the timely collection of imparted credit that is not earning interest for the firm." </p>

<p>I’m not sure what other type of explanation you’re looking for. Whether or not the ratio is “good” can depend on a lot of things and can depend on the firm or industry and is more easily evaluated by looking at the company’s trend.</p>

<p>Basically, the higher the ratio, the faster the company is at collecting their recievables.</p>

5

<p>It means that it takes the customers an avg of 1 month to pay the amount they owe to the company. Obviously, the longer it takes the customer to pay (the lower the ratio), the worst off the company is (because if paid in cash, the company could invest that money and collect interest on it).</p>

<p>When u look at the ratio, it is better to have higher Net Sales and better to have lower receivables on hand (company would rather have the cash on hand ASAP).</p>

6

<p>Why don’t you just wait until the teacher explains it and ask questions in class? You already have a jump start on everyone else…</p>

7

<p>I just read through that portion of my managerial accounting class without thinking much about it. Anyway, here is how I understand the ratio (I admit I forgot it and had to look it up again):</p>

<p>Okay, let’s assume that every single one of your sales were credit sales, that is sales on account or non-cash sales. Alright, let’s say the denominator, the “average accounts receivable balance for the year,” is very small and the numerator, your credit sales is large.</p>

<p>Now, how can this be? If all of your sales are on credit, one would normally think that your account receivable balance should be really big right? The only explanation is that you are good at collecting cash from your customers. Hence, this is the reason why your average accounts receivable balance is small. </p>

<p>So, the bigger your sales on account, we expect a normal business to also have a bigger average accounts receivable balance. If it’s really small, then it means that you’re good at getting the cash. </p>

<p>The higher the sales on account (the numerator) and the lower the average accounts receivable balance (the denominator), </p>

<p>the greater your accounts receivable turnover. </p>

<p>Hope this makes sense. Please let us know what your prof said. Also, what textbook are you guys using?</p>

<p>*Edit: I re-read your post again and realized I didn’t get at the heart of what you’re asking. Now that I think I understand what you’re saying, I honestly don’t know the answer. You mentioned dividing the accounts receivable turnover into 365 days. That’s actually a separate ratio called the average collection period. This is the formula:</p>

<p>Average Collection Period: 365 days/Accounts Receivable Turnover.</p>

<p>This ratio tells you the average number of days it takes a business to collect an account.</p>

<p>However, what I don’t understand, and I assume this is what you’re getting at, is what exactly does the accounts receivable turnover mean as a denominator in the context of this formula. I think of the A/R turnover as a crude proxy for how good the business is at collecting on an account, but I don’t know what it means precisely when you divide it into 365 days.</p>

<p>I’ll ask my prof. next week.</p>