302781 Avg Collection Period 1F

Question 1

Answer 1

45 days.

The average collection period for an entity is generally computed by dividing the number of days in a year (365, 360, or 300 days are commonly used) by the accounts receivable turnover ratio. (AR turnover ratio = net credit sales/average receivable.)

Lisa, Inc.’s, average collection period for 20X2, using a 360-day year, is computed as follows:

Average collection period = 360 ÷ 8* = 45

• AR turnover = $300,000 ÷ [($45,000 + $30,000) ÷ 2] = 8

Question 2

Accounts Receivable Turnover

Answer 2

Accounts receivable turnover (or receivables turnover) is an activity ratio that measures efficiency of credit and collection policies with respect to trade accounts. It confirms the fairness of the receivable balance and reflects the relationship between trade receivables outstanding and credit sales for the period. (Lenient credit policies and poor collection efforts will decrease this ratio.)

Computation: Net credit sales ÷ Average AR

Average AR used is: (Beginning balance + Ending balance) ÷ 2

Limitations on use of this ratio: It should be computed on credit sales only; if using total sales, a shift in the percentage of credit sales to cash sales will affect the ratio. It can be affected by significant seasonal fluctuations unless the denominator is a weighted average.

Question 3

Average Collection Period

Answer 3

Average collection period is an activity ratio that measures the average number of days needed to collect trade accounts receivable. It measures how rapidly the firm’s credit sales are being collected (the lower the ratio, the more efficient the collection).

Computation:

• 365 ÷ AR Turnover, or
• 365 ÷ (Net Credit Sales ÷ Average AR), or
• Average AR ÷ Average Daily Sales, or
• Average AR ÷ (Net Credit Sales ÷ 365).

Limitations on use of this ratio: The ratio should be computed on credit sales only (otherwise a shift in the percentage of credit sales to cash sales will affect the ratio)—use of total sales will affect the ratio. Average accounts receivable should be used, net of the allowance for doubtful accounts.

Question 4

2161.01

Answer 4

Objectives: Short-term liquidity ratios and other measures provide information about how well a firm is able to meet its currently maturing obligations.

• Creditor and management: This is of special interest to creditors, but also important for management to know in order for them to be able to avoid embarrassing last-minute scrambles. Liquidity refers to the composition of current assets and liabilities, primarily assets. A higher proportion of cash or marketable securities is more liquid than a low proportion.
• Short-term liquidity: Operating activity and cash flow ratios are analyzed as part of short-term liquidity. Operating activity ratios measure how effectively and efficiently the firm is carrying out its business—making sales, collecting on sales, and managing inventory. Companies with slow turning inventory and slow paying customers are less liquid. Cash flow gives an indication of the liquidity of a company as does the speed with which noncash current assets convert to cash.

Question 5

2161.02

Answer 5

Definitions

• Current assets: These are cash and other assets that will be converted into cash, sold, or consumed within one year or the operating cycle, whichever is longer. Items are usually listed from highly liquid to less liquid. Increasing current assets is a use of short-term funds for a business. Typical categories are the following:
  1. Cash and cash equivalents
  1. Marketable securities (trading and available-for-sale classifications at fair value)
  1. Notes and accounts receivable (at net realizable value)
  1. Inventories
  1. Prepaid expenses (at unexpired cost)
• Current liabilities: Current liabilities are defined as liabilities to be paid within one year or the operating cycle, whichever is longer. Items are usually presented in order of their liquidation dates and reported at the amount to be paid. Increasing current liabilities are a source of short-term funds for a business. Typical categories are:
  1. accounts payable arising from the acquisition of goods and services.
  1. other accrued liabilities, such as wages payable and interest payable.
  1. notes payable, such as but not limited to commercial paper, short-term bank credit loans, and factoring.
  1. collections of amounts in advance (unearned or deferred revenues).
  1. currently maturing portions of long-term debt.
• Working capital: Working capital is simply the difference between current assets and current liabilities. Creditors are especially interested in working capital as it is the source from which they will be paid.

Question 6

2161.03

Answer 6

Ratios, computational issues, and analysis

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