Leon, the owner of a corner store, should compute the cash conversion or liquidity ratio that indicates how long the store can pay its bills given its current level of cash and accounts receivable. Specifically, the accounts receivable turnover ratio and its related measure, days sales outstanding (DSO) , are relevant here.
- The accounts receivable turnover ratio measures how efficiently the store converts its accounts receivable into cash. It is calculated by dividing net credit sales by average accounts receivable:
Accounts Receivable Turnover Ratio=Net Credit SalesAverage Accounts Receivable\text{Accounts Receivable Turnover Ratio}=\frac{\text{Net Credit Sales}}{\text{Average Accounts Receivable}}Accounts Receivable Turnover Ratio=Average Accounts ReceivableNet Credit Sales
- To understand how long the store can cover its bills based on current receivables, Leon can calculate the average collection period or days sales outstanding (DSO) by dividing 365 by the accounts receivable turnover ratio:
DSO=365Accounts Receivable Turnover Ratio\text{DSO}=\frac{365}{\text{Accounts Receivable Turnover Ratio}}DSO=Accounts Receivable Turnover Ratio365
This tells how many days on average it takes to collect receivables, which helps estimate cash inflows from receivables
. Since Leon wants to know how long the store can pay its bills given current cash and accounts receivable (assuming all receivables are collectible when due), he should look at the liquidity ratio that considers current assets (cash + receivables) relative to current liabilities, such as the current ratio or quick ratio. These ratios indicate the store’s ability to meet short-term obligations. In summary, Leon should compute:
- Accounts Receivable Turnover Ratio to understand collection efficiency.
- Days Sales Outstanding (DSO) to estimate how long receivables take to convert to cash.
- Current Ratio or Quick Ratio to see how long current assets (including cash and receivables) can cover current liabilities.
Among these, the Days Sales Outstanding (DSO) derived from the accounts receivable turnover ratio is most directly related to understanding how long the store can pay its bills based on current receivables and cash
