10 important ratios that managers should measure - Part 4

Poor management of billing and payment cycles is one of the main reasons dealerships can suffer a financial crisis.

Ratio #4: A/R Turnover Ratio
How much money does your dealership have “on the street”?

Many dealers sell on credit, mainly in their Parts and Service areas.

But the reality is that few know exactly how much money they have in debtors’ hands at any given point in time, and even more importantly how this can affect them.

However, this information is crucial for planning and efficiently using the dealership’s resources.

The A/R Turnover Ratio indicates how long it takes the dealer to recover its accounts receivables.

Formula: A/R Turnover Ratio =   Accounts Receivables x 360
                                                               Net sales on credit

An example… Suppose that the dealership has annual sales on credit of $10,000,000 and that at the end of the year they have an A/R balance of $3,500,000. Following the formula, we would have an A/R Turnover Ratio of 126, i.e. the number of days on average that it takes to collect debts.

This ratio may show that the dealership is financing its customers with better terms than those received from suppliers, resulting in a financial disadvantage. That is, if they are collecting from customers at 126 days, but suppliers are paid at 30 days, it is only a matter of time before the dealership runs out of cash to meet payments.

And if that happens, the dealer will have to seek alternative sources of financing (bank loans, overdraft, sale of checks) with their respective costs.

Also, we mustn’t forget that “money on the street” is cash that is tied up and which could instead be used by the dealer to offer more and better services, or to make some kind of investment.

The A/R Turnover Ratio as a strategy

The A/R Turnover Ratio needs to be consistent with the objectives of the dealership.

Using current supplier payment terms, the dealer should project their cash flow to simulate different collection periods and payment terms as a starting point in order to gauge their financial impact.

Based on these scenarios the dealer can plan different strategies:

•  A high A/R Turnover Ratio, in other words offering better payment terms to customers, can be used to expand the client base.
   
•  If the dealer needs more liquidity, they can focus on lowering their A/R Turnover Ratio, for example by enforcing a strict payment term policy.

A high or low A/R Turnover Ratio is not the problem in and of itself. The focus should be on monitoring this ratio, and keeping it consistent with the goals of the dealership.

It is also important to remember that shortening customer payment terms is equivalent to obtaining a source of finance at a cost lower than a bank loan.

The flipside is that if the dealer does not charge interest to customers on credit sales, this is the same as making an investment with zero profitability.

With the right tools the dealer can proactively set a target for their A/R Turnover Ratio instead of constantly reacting to improve it.

All articles in this series:

Indicator #1: Absorption Rate
Indicator #2: Fill Rate
Indicator #3: Obsolete Parts Inventory