Trade Receivable Management Analysis
In this lesson, we will learn how to calculate and interpret trade receivables ratios and compare trade receivables management performance across different years of the business, and with other businesses.
Related Lessons:
Purpose of Trade Receivable Management
Trade receivable management is important as goods or services have been transferred to the customers but cash from these sales has yet to be received. Debts not collected back on time reduces the business cash flow which leads to poor liquidity.
Efficient trade receivable management means the business is able to:
- maintain it sales
- extend credit to customer who are credit-worthy
- have an effective collection policy
Calculating Trade Receivable Ratios
There are two trade receivable ratios that are used to help a business measures its efficiency in managing trade receivables.
A) Rate of Trade Receivable Turnover
This ratio measures the business’ effectiveness in extending credits and collecting debts from its credit customers.
To calculate, we take Net Credit Sales or Net Service Fee Revenue (for a service business) divided by Average Trade Receivables. This gives us the number of times debts from trade receivables is collected during the financial year.
Net credit sales or Net service fee revenue / Average trade receivables = x times
Average trade receivables are calculated by taking trade receivables at the beginning of the financial year plus trade receivables at the end of the financial year, divided by 2.
(Beginning trade receivables + Ending trade receivables) / 2
B) Trade Receivable Collection Period
This ratio measures the number of days a business takes to collect back its debts from trade receivables.
To calculate, we take Average trade receivables divided by Net Credit Sales or Net Service Fee Revenue (for a service business) and multiply the answer by 365 days. This gives us the number of days the business takes to collect its debts back.
(Average trade receivables / Net credit sales or Net service fee revenue) x 365 days = x days
Interpreting Trade Receivable Ratios
A low rate of trade receivable turnover ratio is usually accompanied by long collection period. This indicates that the business is taking a longer time to collect its debts, therefore less frequent collection during the year.
Possible causes include:
- Ineffective collection policy
- Lenient credit policy
- Weak credit control, extending credit to less credit-worthy customers
This results to a decrease in cash flow and profit due to high uncollectible debts and administrative cost.
To improve, the business may:
- Gives cash discount to reward prompt payment
- Impose late payment charges
- Perform more checks on customers before extending credit to them
A high rate of trade receivable turnover ratio with a short collection period means that the business collecting its debts back on time. The business may have:
- Effective collection policy
- Strong credit control
- Extended credit only to credit-worthy customers
This situation is preferred as it increases cash flow thus liquidity and reduces expenses such as impairment loss on trade receivables and administrative costs.