Extending Credit

Which ratio most closely tracks the amount of credit a firm is extending to it's customers?

(a) Debt ratio
(b) Inventory Turnover
(c) Accounts Receivable Turnover
(d) None of the above

Correct answer is C

Accounts Receivable Turnover Ratio (Day's Sales Outstanding) measures the number of times a company's accounts receivables are collected and turned into cash. Accounts Receivable Turnover is determined by taking the quotient of Accounts Receivable by the average sales per day (or annual sales / 365 days). This Ratio can be used to determine how much a company is extending credit to its' customer base. A larger Turnover Ratio means that a company is taking longer to collect on the debt extended to the customer and is therefore extending more credit to it's customers. One extreme would be a cash business that has zero accounts receivable turnover ratio since there is no accounts receivable and thus is not extending credit to its customers.

(a) Debt Ratio is incorrect because it is a measure of a company's debt to its assets. This is more of a measure of how much debt is being extended to a company by a bank relative to the amount of assets a company owns.

(b) Inventory Turnover is incorrect because it measures how many times a company has turned over (sold and replaced) it's inventory in a specific period of time. Determined by taking the qutient of sales to Average inventory balance. No deterministic information can be obtained from this accounting ratio.

(d) None of the above is incorrect since the best fit is found in C.

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