Problem 9 - Accounting

Question

The following data are taken from the financial statements of Ovation Industries Inc. Terms of all sales are \(1 / 10, \mathrm{n} / 60\). \begin{tabular}{lcr} & Current Year & Preceding Year \\ \hline Accounts receivable, end of year & \(\$ 48,219\) & \(\$ 52,603\) \\ Monthly average accounts receivable (net) & 45,070 & 46,154 \\ Net sales & 320,000 & 300,000 \end{tabular} a. Determine for each year (1) the accounts receivable turnover and (2) the number of days' sales in receivables. Round to nearest dollar and one digit after the decimal place. b. What conclusions can be drawn from these data concerning accounts receivable and credit policies?

Step-by-Step Solution

Answer

Accounts receivable turnover improved, and days' sales in receivables decreased, indicating better receivables management and collection efficiency.

Step 1: Calculate Accounts Receivable Turnover (Current Year)

The accounts receivable turnover is calculated as follows: \[ \text{Accounts Receivable Turnover} = \frac{\text{Net Sales}}{\text{Average Accounts Receivable}} \] For the current year: \[ \text{Accounts Receivable Turnover} = \frac{320,000}{45,070} = 7.1 \] Therefore, the accounts receivable turnover for the current year is 7.1.

Step 2: Calculate Days' Sales in Receivables (Current Year)

Days' sales in receivables is calculated using: \[ \text{Days' Sales in Receivables} = \frac{360}{\text{Accounts Receivable Turnover}} \] Using the turnover from Step 1: \[ \text{Days' Sales in Receivables} = \frac{360}{7.1} \approx 50.7 \] Hence, days' sales in receivables for the current year is approximately 50.7 days.

Step 3: Calculate Accounts Receivable Turnover (Preceding Year)

Using the same formula as in Step 1 for the preceding year: \[ \text{Accounts Receivable Turnover} = \frac{300,000}{46,154} \approx 6.5 \] Thus, the accounts receivable turnover for the preceding year is 6.5.

Step 4: Calculate Days' Sales in Receivables (Preceding Year)

Days' sales in receivables for the preceding year is calculated as follows: \[ \text{Days' Sales in Receivables} = \frac{360}{6.5} \approx 55.4 \] Therefore, days' sales in receivables for the preceding year is approximately 55.4 days.

Step 5: Analyze Results and Draw Conclusions

Comparing both years, the Accounts Receivable Turnover has increased from 6.5 to 7.1, indicating improved efficiency in collecting receivables. The number of days sales in receivables decreased from about 55.4 days to 50.7 days, suggesting faster collection times. These results imply that the company has potentially tightened its credit policies or enhanced its collection processes.

Key Concepts

Days' Sales in Receivables

Understanding "Days' Sales in Receivables" is crucial for assessing how efficiently a company collects owed money. This metric gives an average number of days a company takes to collect payment from its customers.
It is derived from the accounts receivable turnover ratio and uses the formula: \[\text{Days' Sales in Receivables} = \frac{360}{\text{Accounts Receivable Turnover}}\]This calculation assumes 360 days in a year for simplicity and analysis consistency. By calculating this, you can determine if the company is receiving payments quicker or slower than previous periods.
For Ovation Industries, this improved from approximately 55.4 days to 50.7 days. Shorter days in receivables indicate better efficiency and potentially stronger cash flow, since cash is being collected faster. This means capital is available more quickly for other investments or obligations.

Financial Statement Analysis

Financial statement analysis helps stakeholders understand an organization's health by interpreting data from financial statements. One of the most insightful metrics when analyzing these statements is the accounts receivable turnover.This turnover rate reveals how many times over a company collects its average accounts receivable during a specific period. The formula to compute it is:\[\text{Accounts Receivable Turnover} = \frac{\text{Net Sales}}{\text{Average Accounts Receivable}}\]A higher turnover ratio, as seen in Ovation Industries moving from 6.5 to 7.1, indicates efficient credit policies or improved collections. Companies use this analysis to make informed decisions about policies and find ways to manage their cash flow better.
Through comparison of different years, as shown in the results from Ovation Industries, analysts can spot trends or areas for improvement, such as enhancing the credit review process or collection strategies.

Credit Policies

Credit policies are the guidelines that a company follows when extending credit to its customers. These policies significantly impact accounts receivable turnover and days' sales in receivables. Effective credit policies balance attracting customers with maintaining cash flow. A company might adjust its policies to reduce the amount of time it takes to collect payments, such as offering early payment discounts or stricter credit terms.
For Ovation Industries, the improved turnover and reduced days' sales in receivables suggest more stringent credit control or effective collection practices. Enhancements could include comprehensive credit checks, vigilant monitoring of accounts receivable, and quicker follow-ups on overdue accounts. In practice, well-established credit policies help minimize bad debts and ensure the company has a reliable inflow of cash, which is essential for sustaining operations smoothly.