Thank you so much for your help! A company would like to simplify the process th

Question

Thank you so much for your help!

A company would like to simplify the process they use to grant customers the ability to buy their products on account. Their customers are often other small businesses producing products that use sugar in their manufacturing process. They would like to develope a system where we look at two ratios in order to quickly "prescreen" potential credit customers. What two accounting ratios would help illsutrate this approach? The key idea is to create a report that the people in the A/R group could review in making a decision about whether to extend credit to a potential customer. What are these two ratios and argue why these ratios do the best job of signaling the creditworthiness of the potential customer, also are there any limitations to this approach? What graphs could be used in excell to help demonstrate these ratios?

Explanation / Answer

Two accounting ratios that are used for customers are receivable turnover ratio and Days sales outstanding.

Receivable Turnover ratio: This ratio is used to measure the efficiency of extending credit and collecting the same from the customer. This ratio shows the average number of times the company collects dues from the customer. This ratio can be used for a particular customer or accounts receivable as a whole.

Formula for Receivable turnover ratio is:

Net credit sales/Average accounts receivable

Days sales outstanding ratio: This ratio is used to measure the number of days the dues are outstanding. The shorter the DSO, the better the company’s liquidity.

Formula for days sales outstanding is:

360 or 365 days /receivable turnover ratio

These two ratios show how many times a particular customer pays his dues and for how many days the sales is outstanding in a particular period. If any customers receivable ratio is low and days sales outstanding is longer, the company should not give credit to that customer.

Limitation:

Sometime companies use total sales instead of net sales, which inflate the ratio.

Also the average accounts receivable is used to calculate the ratio but sometime receivable vary dramatically over the period and start and end point does not show the correct picture of accounts receivables. Thus the beginning and ending balance should be picked so as to represent the correct picture of the period it belongs.

Line graph can be used to demonstrated these ratios in excel

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