Is Your Accounts Receivable Turnover Ratio Costing You Dearly?

Is your Accounts Receivable Turnover costing you dearly?

No idea what I am talking about?

Then yes, an explanation is in order.

However, before that, let us establish something important.

Accounts Receivable Turnover Ratio is a key hotel financial ratio.

It is a Liquidity based Ratio.

I call financial ratios as early warning systems.

Remember the car instrument panel dashboard metaphor from Part 1?

It is like missing a key reading on your dashboard.

Say, you do not notice that the fuel in your car is running low.

The next thing that will happen is your car will stop running.

You can consider liquidity something similar to that.

If your liquidity runs low, you cannot run the hotel efficiently.

Accounts Receivable Turnover ratio is a liquidity measure.

What are Accounts Receivables?

In Part 2 of this 12 part Ultimate Guide, you learned about liquidity.

Liquidity is the ability of an asset to be converted into cash.

Let us quickly revisit the current assets in a hotel balance sheet.

Why?

Because Accounts Receivable is a current asset.

For example, Current Assets (see below) are normally these three common types:

• Cash and Bank Balances
• Accounts Receivable
• Inventories

These feature prominently in a hotel balance sheet.

Accounts Receivables are uncollected sales.

You could describe them as sales made but money not collected yet.

So, there is a time lag between earning the revenue and collecting the money for it.

Accounts Receivables are converted into cash during a normal operating cycle.

In other words, during a financial year.

Accounts Receivable Turnover Ratio is one of the key liquidity ratios.

Take a look at the infographic below.

Now let us learn what Accounts Receivable Turnover Ratio is.

This Blog Post will cover:

Accounts Receivable Turnover Ratio

What is Accounts Receivable Turnover Ratio?

Why are Accounts Receivable listed before Inventories?

Because Accounts Receivable represent sales already made but money not collected.

On the other hand, inventories are yet to be sold and hence not as liquid.

Inventories are considered the least liquid of current assets.

Now, we broadly know the common types of current assets.

Let us understand this Ratio.

We will also see why as a hotel manager you must know what this ratio is about.

Accounts Receivable Turnover Ratio measures the speed of conversion of this current asset.

In other words:

• the ratio of what revenue a hotel earns Vs
• How much of that revenue is tied up in accounts receivable.

See infographic below:

Higher the ratio, the better will be its current and acid test ratio (Part 1 of this Ultimate Guide).

In other words, higher the ratio, the better the liquidity.

Hotel Owners prefer a higher ratio since this means lesser investment in non-productive current assets.

It of course means that too tight a credit policy will result in loss of revenue opportunities.

Hotel Management needs to balance:

• a healthy accounts receivable turnover ratio with
• maximum revenue opportunities.

Ratio Formula

Accounts Receivable Turnover Ratio is simply the ratio of Revenue to Average Accounts Receivable.

The formula is:

Total or Credit Revenue / Average Accounts Receivable

Take a look at the Current Assets and Liabilities of Paradise Hotel.

In particular, notice the Accounts Receivable for the two years 2018 and 2019.

In the above formula, two elements have to be explained:

• Revenue in the ratio can be Total or Credit.
• Credit Revenue does not take into account Cash Sales.
• It is a more accurate representation of revenue than Total Revenue.
• Average Accounts Receivable is simply the average of the opening and closing figures.
• Averaging is done to ensure that a high or low opening or closing accounts receivable does not distort the ratio.

So, what is the “Turnover” in the Accounts Receivable Turnover Ratio.

By comparing credit revenue with average accounts receivable, you arrive at the movement.

Movement of revenue into accounts receivable.

In a way you could say you are measuring the extent of liquidity.

Let us now see the example using the Paradise Hotel shown above.

Ratio Example

The Accounts Receivable for Paradise Hotel as of 12.31.2018 & 12.31.2019 are:

• 2018 - $90,000
• 2019 - $140,000

Total Revenue for 2019 from Income Statement: $324,469

The Accounts Receivable Turnover Ratio for Paradise Hotel as of 31.12.2019 is:

Total Revenue / Average Accounts Receivable OR

$324469 / [($90000 + $140000)/2] = $324469 / $115000

= 2.82

This is a low Accounts Receivable Turnover Ratio.

The indication is that accounts receivables are not very liquid.

Let us now see how it is useful to calculate this ratio.

More importantly, how you can avoid some alarming situations shown below.

How is the Ratio useful?

For Paradise Hotel, you found the that Accounts Receivable Turnover Ratio is 2.82.

This is a low liquidity ratio.

If you remember, we said that higher the ratio the better the acid test ratio.

Acid Test Ratio (Part 1 of this Ultimate Guide) is the best indicator of liquidity.

Liquidity is one of the key measures of short term solvency.

In other words, the ability to pay current liabilities with current assets.

Is the hotel able to cover its short term liabilities with its short term assets?

Or, how liquid are the hotel’s current assets?

And how quickly does the hotel collect its accounts receivables.

So, they are able to provide the cash necessary to pay current liabilities.

This is the reason the Accounts Receivable Turnover Ratio is critical.

A varied calculation is make the accounts receivable a collection based ratio.

Let us see how that works.

Easier Way to Understand Ratio

A common way of translating the Ratio is using collection as days.

In other words, how many days it takes to collect the accounts receivables.

This converts the ratio into a more understandable one.

Meaning, a ratio that states the collection period in number of days.

Higher Average Collection Period will indicate inefficiency in collecting accounts receivables.

The calculation is: divide number of days in year by the Accounts Receivable Turnover Ratio.

The formula is:

365 days / Accounts Receivable Turnover Ratio.

In the case of Paradise Hotel the calculation will be:

365 / 2.82 = 129 days Average Collection Period.

This is an alarming result and reflects highly inefficient collection.

It emphasizes the early warning system we know about.

An average Collection Period of less than 30 days is considered efficient.

Meaning accounts receivable collected within 30 days of revenue earned is considered good.

On the other hand, if this collection goes into 60 day territory, it becomes a problem but not yet alarming.

If collection has entered into the 90 day period, there is real danger that the debt may not be collectible.

That means a loss to the hotel.

For Paradise Hotel example earlier, Average Collection Period is 129 days.

There is a great danger of these accounts receivable turning into bad debts & losses.

This is the reason why Accounts Receivable Turnover Ratio is so critical.

Reasons Your Hotel Average Collection Period May Become Alarming

What are some reasons you could avoid being in the situation Paradise Hotel finds itself in?

First, and hopefully the reason is this.

Accounts Receivable outstanding amounts tend to age quickly.

They can go from current (30 days) right beyond 90 days if not followed up.

So, regular follow up from your Credit department is a must.

Second, and a more serious issue is this.

Credit check may not have been conducted on the outstanding accounts.

In other words, are the companies credit worthy?

This is at the time of considering allowing the organization to be approved credit terms.

A healthy accounts receivable turnover ratio begins with prudent credit checks.

This is a reason you do not want to find yourself in for your hotel.

Absence of credit checks leads to two things:

• They begin with accounts receivables going from 30 to 90 days & more and
• Worse, they become first doubtful of collection and
• Finally turn bad which is a loss to the hotel.

Further you must ensure that you do not fall prey to some traps stated below.

Traps You Must Avoid with the Ratio

As we have said earlier, financial ratios are mere indicators.

It is critical that we understand how they are calculated.

Total Revenue and Accounts Receivables play a part in this ratio.

So, movement in revenue up or down must be taken into account.

Similarly, movement in accounts receivables must also be considered.

What this simply means is that accounts receivables may have been collected in a subsequent month.

In effect, the position as of the end of the year may not be relevant any more.

129 days outstanding accounts receivable is indeed an alarming number.

However, it may have been rectified in a later month through quick collection.

You must therefore monitor the collection period results closely across months.

This is to ensure that it does not spiral out of control.

Big Picture of Hotel Liquidity

At the end of the day, you must step back and take a big picture overview of liquidity.

Meaning, look at the liquidity picture in entirety.

And not just look at accounts receivable turnover ratio individually.

The big picture will be how liquid the total current assets are.

That will allow you to run your hotel operation without any cash resource crunch.

Chapters in this Ultimate Guide on Hotel Financial Ratios

This Ultimate Guide is a twelve part series which will cover the following key areas:

• CHAPTER 1 of 12 - Hotel Financial Ratios - Why should you care?
• CHAPTER 2 of 12 -Liquidity Ratios Intro - Acid Test Ratio
• CHAPTER 3 of 12 -Liquidity Ratios - Accounts Receivable Turnover Ratio
• CHAPTER 4 of 12 -Liquidity Ratios - Working Capital
• CHAPTER 5 of 12 -Solvency Ratios - Net Worth
• CHAPTER 6 of 12 -Solvency Ratios - Debt Equity Ratio
• CHAPTER 7 of 12 -Activity Ratios - Inventory Turnover Ratio
• CHAPTER 8 of 12 - Profitability Ratios Intro - Gross Operating Profit
• CHAPTER 9 of 12 - Profitability Ratios - Return on Investment Ratio
• CHAPTER 10 of 12 - Profitability Ratios - Return on Equity Ratio
• CHAPTER 11 of 12 - Asset Management Ratios Intro - Asset Turnover Ratio, RevPAR
• CHAPTER 12 of 12 - How to Identify Warning Signs in Hotel Financial Ratios

Next Week - Working Capital 

We will dive into the third of hotel liquidity ratios - Working Capital.

We will see:

• What working capital is.
• Why is this liquidity ratio considered so critical?
• How do you read and use working capital?

and more…

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