Financial Accounting: An Integrated Statements Approach, 2nd Edition

Monitoring Collections

Effective internal controls over receivables and credit granting require the seller to

monitor collections of receivables on a routine basis. One means of monitoring receiv-

ables and collections is to prepare an aging schedule. We illustrated the aging of

receivables earlier in this chapter.

In some cases, a company in financial distress will still try to purchase goods and

services on account. In these cases, sellers must be careful in advancing credit to such

companies, because trade creditors have low priority in the event of bankruptcy. To

help sellers avoid extending credit to such companies, third-party services specialize

in evaluating financially distressed customers. These services analyze the credit risk of

buyers by evaluating recent management payment decisions (who is getting paid and

when), court actions (if in bankruptcy), and other supplier credit tightening or sus-

pension actions. Such information helps a seller monitor and determine trade credit

amounts and terms with financially distressed customers.

ACCOUNTS RECEIVABLE TURNOVER AND

DAYS’ SALES IN RECEIVABLES

In addition to preparing an aging of receivables schedule and monitoring concentra-

tions of credit risk, several financial statement ratios are also useful in monitoring re-

ceivables and their collection. Two of these ratios are described and illustrated in the

following paragraphs.

Businesses granting long credit terms normally have relatively greater amounts

committed to accounts receivable than those granting short credit terms. In either case,

businesses normally desire to collect receivables as promptly as possible. The cash col-

lected from receivables improves solvency and lessens the risk of loss from uncol-

lectible accounts. Two financial measures that are especially useful in evaluating

efficiency in collecting receivables are (1) the accounts receivable turnover and (2) the

number of days’ sales in receivables.

Theaccounts receivable turnovermeasures how frequently during the year the ac-

counts receivable are being converted to cash. For example, with credit terms of 2/10,

n/30, the accounts receivable should turn over more than 12 times per year. The ac-

counts receivable turnover is computed as follows:^5

Accounts Receivable Turnover 

Net Sales

Average Accounts Receivable

The average accounts receivable can be determined by using monthly data or by

simply adding the beginning and ending accounts receivable balances and dividing by

two. For example, using the following financial data (in millions) for Starbucks, the

2004 accounts receivable turnover is computed as 41.6.

370 Chapter 8 Receivables

Compute and interpret the

accounts receivable

turnover and the number

of days’ sales in

receivables.

9

5 If known, credit sales can be used in the numerator. However, because credit sales are not normally dis-

closed to external users, most analysts use net sales in the numerator.