Collection of accounts receivable through the mail should be initially listed by personnel in the
Activity or Turnover RatiosReceivable turnover and inventory turnover, two important activity or asset turnover ratios, correlate to sales, the outcome of which determines how efficiently management utilizes resources it commands with respect to sales. Lenders pay close attention to these two ratios because success depends on both solid customer portfolios and inventory that moves. We review the average collection period (same results as accounts receivable turnover), inventory turnover, fixed asset turnover, total asset turnover, and working capital turnover. Show Average Collection PeriodThe average collection period (ACP) determines the time it takes to convert accounts receivable into cash. ACP factors can be external or internal. For example, economic fluctuations affecting a specific business sector will affect the number of days until payments arrive. If only a few companies are affected, lenders tend to blame the firm’s management, not the industry. Average collection period = (accounts receivables/sales) × 365 = $88,571/$586,895 × 365 = 55 days
A tight ACP usually suggests high-quality receivables and improved cash flow. Conversely, increases over the past 3 years may mean cash flow problems, which might lead lenders to request an accounts receivable aging schedule. An aging schedule quickly points to collection difficulties that may result in lost revenues and higher bad debt expenses. Weak collection periods hint at stale inventory and a host of other financial woes. However, there is another side to this coin. Increases may mean liberal credit standards aimed at attracting new customers, increasing market share, and making more money. First Central Bank should first rule out macroeconomic and industry forces since these two forces are exogenous. For instance, if management argues receivables slowed up due to a sluggish economy, bankers will compare that finding to benchmarks or industry average. However, the industry average is 32, not 54 days. Perhaps 22 days’ difference does not sound like much but if cash flow is compromised, watch out! How worrisome are small shifts in the average collection period? Let us replace the firm’s 54-day average collection period with the 32-day industry average, and enter the firm’s fiscal sales (365 is a constant). We solve for a new dependent variable – pro forma accounts receivable – that is, fiscal 2014 receivables the firm would have posted on its balance sheet had management been as collection-efficient as the industry average. Here is the result: Recall that the average collection period = (accounts receivables/sales) × 365 = $88,571/$586,895 × 365 = 55 Now solve for pro forma 2014 fiscal accounts receivable given 2014 fiscal sales $586,895 and industry average collection period of 32 days. Thus, 2014 accounts receivable pro forma = 32 ($586,895)/365 = $52,905 Fiscal receivables minus pro forma receivables = $88,571 − $52,905 = $35,667, indicating at fiscal date good money was floating in space (in the possession of customers). In other words, fiscal cash flow had been compromised to the tune of $35,667 simply because receivables were not paid. Smart lenders employing similar pro forma techniques can differentiate between accounts receivable increases linked to normal growth as opposed to receivable increases tied to lackluster collection efforts. In this example, Jones Designs, Inc.’s lenders will ask for supplemental information – receivable aging, customer list, collection efforts, credit standards, credit terms, and trade discounts, since it is possible the firm has exchanged one weak asset – stale inventory – for another, lower quality receivables. Bad Debt Expense/SalesLenders evaluate receivables quality making use of the ratio bad debt expense/sales. A higher bad-debt-to-sales ratio usually indicates lax credit standards or compromised financial condition of the customer. Inventory TurnoverThe inventory turnover depicts the number of times inventory turned over during a fiscal year and is usually benchmarked to industry results. Inventory control is crucial to well-run operations, and depends on the interrelationship between raw materials, work-in-process, and finished goods. Raw material inventory relates to your firm’s anticipated production, seasonality, and reliability of suppliers. If raw material inventories are salable and commodity-like, your lender will view inventory as more liquid than, say, work-in-process inventory. While raw materials may be more liquid, a large amount of raw materials on hand may also indicate speculative holdings in anticipation of price increases or shortages. Work-in-process inventory is associated with the length of the production cycle. Dynamics include manufacturing efficiency, product engineering techniques, and maintenance of skilled workers. Excessive work-in-process inventory suggests production slowdowns and/or manufacturing inefficiencies, which could turn into a nightmare scenario if you have to inform customers that shipments will be delayed. A high turnover ratio is not automatically good. Stock-outs, which lead to lost sales, may be due to the incapacity to accurately project sales patterns or master production. The clues are all there, concealed within the ratio. Inventory turnover (cost) = cost of goods sold/inventory = $499,928/$139,976 = 3.6 Inventory turnover (sales) = sales/inventory = $586,895/ $139,976 = 4.2
In the case of Jones Designs, inventory turnover fell below the industry average and is trending downward, suggesting (1) too much inventory on hand, (2) liquidity may be worse than indicated (by the current ratio), and (3) inventory could be obsolete and may need to be written off. The Fixed Asset TurnoverDirecting the firm’s capital equipment policies is central to management’s goal of maximizing shareholder value. Investment in fixed assets reduces cash flow in periods when investments are made. As a result, cash generated by productive assets must offset initial investment outflows, producing a positive net present value. In other words, this ratio reflects cash flow quality and sustainability. Fixed asset turnover = sales/net fixed assets = $586,895/$48,539 = 12.09
Jones Designs, Inc.’s fixed asset turnover is in level with the industry’s fixed asset turnover. Let us review the cues suggesting that the firm is operating fixed assets efficiently. A high ratio suggests the following: 1.The firm’s efficient use of property plant and equipment has resulted in a high level of operating capacity. Merger and divestment activity has changed the composition and size of fixed assets on the consolidated balance sheet. 3.The firm has increased plant capacity, utilizing more machines. 4.Old equipment was sold. There is a negative side to this ratio. For example, a high turnover ratio may indicate that management allowed plant facilities to wear down. The big question that remains is whether high turnover is good or bad. Your lender will examine the fiscal cash flow seeking answers (Chapter 6). The following are a few warning signals the lender will watch for: •The cash flow statement reveals a deferred tax runoff. •Depreciation expense (related to older machinery) is larger than capital expenditures (related to replacement costs). •Unfilled orders (backlogs) increase. •Work-in-process inventory expands due to production slowdowns. •Reduced operating leverage as additional labor is channeled to production. •Gross profit margin eroded appreciably. Working Capital TurnoverWorking capital is a general measure of liquidity and represents the margin of protection short-term creditors expect. As we saw earlier, working capital is the excess of current assets over current liabilities. Sufficient working capital is essential to meet operating needs along with supplier and short-term debt obligations. Working capital turnover = sales/working capital = $586,895/ $103,077 = 5.6
Total Asset TurnoverHow efficiently does a firm utilize capital? How many sales dollars are generated by each total asset dollar? Total asset turnover = sales/total assets = $586,895/$288,803 = 2.0
In 2014 total asset turnover dipped significantly below the industry average, suggesting that the firm had to employ more assets per sales dollar than the industry average, implying reduced asset productivity. By the process of elimination, since the fixed assets turnover is equal to the industry’s, problems in this business can be traced to receivables and inventory (current asset management). Average Settlement Period or Accounts Payable TurnoverThe average settlement period measures the time it takes to pay creditors. The accounts payable turnover is the number of times trade payables turn over in 1 year. Average settlement period = accounts payable/average purchases per day Accounts payable turnover = cost of goods sold/accounts payable Average settlement period = (accounts payable/cost of goods sold) × 365 = $59,995/$499,928 × 365 = 44 days
High ratios suggest shorter time between purchase and payment. If, for example, the firm’s payables turned over slower than benchmark’s, likely causes would include disputed invoices, extended terms, late payments, and cash flow problems. How is the collection of accounts receivable recorded?We can make the journal entry for the collection of accounts receivable by debiting the cash account for the amount received and crediting the accounts receivable to remove the collected amount from the balance sheet.
Which should be recorded in accounts receivable?Accounts receivable is money that your customers owe you for buying goods and services on credit. Your accounts receivable consist of all the unpaid invoices or money owed by your customers. Accounts receivable are recorded as an asset on your company's balance sheet.
Who is responsible for maintaining accounts receivable in an Organisation?The accountant or the person responsible for taking due care of the accounts receivables must record all the due dates of the payments to be received. The timely and prompt recording of the accounts receivable leads to receiving the payments on time from the customers.
Who will send the confirmation of accounts receivable to client's customers?Once the confirmation is ready to be sent, the auditor is the one who sends the confirmation to the client's customers. The confirmation should not send by the client to its customer. This is to confirm that evidence that is collected from the confirmation is considered third-party information.
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