Free on Board (FOB) is a shipment term used to indicate whether the seller or the buyer is liable for goods that are damaged or destroyed during shipping. "FOB shipping point" or "FOB origin" means the buyer is at risk once the seller ships the product. The purchaser pays the shipping cost from the factory and is responsible if the goods are damaged while in transit. "FOB destination" means the seller retains the risk of loss until the goods reach the buyer.

KEY TAKEAWAYS

• Free on Board (FOB) is a term used to indicate who is liable for goods damaged or destroyed during shipping.

• "FOB origin" means the buyer is at risk once the seller ships the product.

• "FOB destination" means the seller retains the risk of loss until the goods reach the buyer.

• The terms of FOB affect the buyer's inventory cost—adding liability for shipped goods increases inventory costs and reduces net income.

• Legal definitions of FOB may differ between individual countries.

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Free On Board

Understanding Free on Board (FOB)

Historically, FOB was used only to refer to goods transported by ship—in the U.S., the term has since been expanded to include all types of transportation. Contracts involving international transportation often contain abbreviated trade terms that describe matters such as the time and place of delivery, payment, when the risk of loss shifts from the seller to the buyer, and who pays the costs of freight and insurance.

The most common international trade terms are Incoterms, which the International Chamber of Commerce (ICC) publishes, but firms that ship goods within the U.S. must also adhere to the Uniform Commercial Code (UCC).12 Since there is more than one set of rules, and legal definitions of FOB may differ from one country to another, the parties to a contract must indicate which governing laws are being used for a shipment.

Any vendor-client transaction needs to make clear FOB terms in the purchase order as these terms determine which party will pay for shipping and insurance costs. However, it's worth noting that FOB status does not determine ownership—ownership is determined in the bill of sale or agreement between the buyer and seller.

If the terms include the phrase "FOB destination, freight collect," the seller is responsible for the goods until they are delivered, and the buyer is responsible for freight charges. If the terms include "FOB destination, freight prepaid," the seller is responsible for goods until delivered, provided there are no insurance claims. In this scenario, the seller is responsible for the freight charges. On the other hand, "FOB origin" or "FOB shipping point" indicates the opposite—that the buyer is responsible for goods soon as the vendor ships the goods.

Depending on the FOB terms, the more often a company orders inventory, the more shipping, and insurance costs it will incur. Companies can also incur costs when placing an inventory order through the price of hiring labor to unload the goods as well as the cost of leasing a warehouse to store the goods. A company can lower its inventory costs by ordering greater quantities and reducing the number of individual shipments it brings in.

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TESLA INC

AAPL

APPLE INC

NKE

NIKE INC

AMZN

AMAZON.COM, INC

WMT

WALMART INC

SELECT INVESTMENT AMOUNT

$

SELECT A PURCHASE DATE

              2 years ago                      5 years ago                      10 years ago         

CALCULATE

Example of Free on Board (FOB)

Assume, for example, that Acme Clothing manufactures jeans and sells them to retailers such as Old Navy. If Acme ships $100,000 in jeans from their factory in Los Angeles to an Old Navy store in New York City using the term FOB shipping point (FOB Los Angeles), Old Navy is liable for any loss while the goods are in transit and would purchase insurance to protect the shipment.

On the other hand, if the goods are shipped to FOB destination (FOB New York), Acme Clothing retains the risk until the freight reaches Old Navy's offices and would insure the shipment against loss.

Special Considerations

Shipping terms affect the buyer's inventory cost because inventory costs include all costs to prepare the inventory for sale. Using the same example, if the jeans were shipped using FOB shipping point terms, Old Navy’s inventory cost would have to include the $100,000 purchase price and the cost of insuring the goods against loss during shipment.

Similarly, when Old Navy incurs other costs related to inventory, such as renting a warehouse, paying for utilities, and securing the warehouse, those costs are also added to inventory. This accounting treatment is important because adding costs to inventory means the buyer does not immediately expense the costs and this delay in recognizing the cost as an expense affects net income.

Another reason companies should be acutely aware of free on board (FOB) terms is that FOB establishes when the goods become an asset on the buyer's balance sheet. This becomes especially important if a transaction occurs close to the transition from one accounting period to the next, such as the end of a calendar or fiscal year.

Accountants need to know whether to include the freight on the company's balance sheet when the goods are shipped or when they are delivered. FOB destination would mean the seller carries the inventory on their balance sheet until it's delivered. FOB shipping point means the buyer records merchandise when it's shipped.

Criticism of FOB

A 2018 study by Ki-Moon Han of the Korea Research Society for Customs looks at the complexities of FOB contracts and explains that they are often misunderstood. According to Han, more sophisticated contracts are increasingly used to meet the needs of international traders.

The author states that there is often confusion because the parties involved in the contracts misunderstand incoterms FOB, sales contracts, carriage contracts, and letters of credit. Han urges companies to use caution and to clarify which type of FOB they are entering into so that the risks and liabilities are clear.3

The latest publication of Incoterms, Incoterms 2020, is available for purchase on the International Chamber of Commerce website.4

Each party should have a firm understanding of free on board (FOB) to ensure a smooth transfer of goods from the vendor to the client. Regardless of whether that transfer occurs on the domestic or international level, FOB terms can have a big impact on inventory, shipping, and insurance costs.

How does FOB work?

FOB stands for "free on board" and indicates when liability goods are transferred from a seller to a buyer.

What is FOB pricing?

The costs associated with FOB include transportation of the goods to the port of shipment, loading the goods onto the shipping vessel, freight transport, insurance, and unloading and transporting the goods from the arrival port to the final destination.

Who pays freight on FOB origin?

If the terms include the phrase "FOB origin, freight collect," the buyer bears the responsibility of the goods being shipped and is responsible for freight charges. If the terms include "FOB origin, freight prepaid," the buyer of goods assumes the responsibility of goods at the point of origin, and the seller pays the cost of shipping.

What is the difference between FOB and CIF?

CIF (Cost, Insurance, and Freight) and FOB (Free on Board) are two widely used INCOTERM agreements. Although the definition of both terms can differ across countries and is ultimately determined by each vendor-client contract, historically, FOB transfers liability from seller to buyer when the shipment reaches the port or other facility designated as the point of origin. With a CIF agreement, the seller pays costs and assumes liability until the goods reach the port of destination chosen by the buyer.

Indemnity is a comprehensive form of insurance compensation for damages or loss. When the term indemnity is used in the legal sense, it may also refer to an exemption from liability for damages.

Indemnity is a contractual agreement between two parties. In this arrangement, one party agrees to pay for potential losses or damages caused by another party. A typical example is an insurance contract, in which the insurer or the indemnitor agrees to compensate the other (the insured or the indemnitee) for any damages or losses in return for premiums paid by the insured to the insurer. With indemnity, the insurer indemnifies the policyholder—that is, promises to make whole the individual or business for any covered loss.

KEY TAKEAWAYS

• Indemnity is a comprehensive form of insurance compensation for damages or loss.

• In this type of arrangement, one party agrees to pay for potential losses or damages caused by another party.

• A typical example is an insurance contract, in which the insurer or the indemnitor agrees to compensate the other (the insured or the indemnitee) for any damages or losses in return for premiums paid by the insured to the insurer.

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Insurance

How Indemnity Works

An indemnity clause is standard in the majority of insurance agreements. However, exactly what is covered, and to what extent, depends on the specific agreement. Any given indemnity agreement has what is called a period of indemnity, or a specific length of time for which the payment is valid. Similarly, many contracts include a letter of indemnity, which guarantees that both parties will meet the contract stipulations (or else an indemnity must be paid).

Indemnity is common in agreements between an individual and a business (for example, an agreement to obtain car insurance). However, it can also apply on a larger scale to relationships between businesses and government or between governments of two or more countries.

Indemnity clauses can be complicated to negotiate and can lead to increased costs of services because of the increased risk of the contract.

Sometimes, governments, a business, or an entire industry must take on the costs of larger issues on behalf of the public, such as outbreaks of disease. For example, according to Reuters, Congress authorized $1 billion to fight a bird flu epidemic that devastated the U.S. poultry industry in 2014 and 2015. The U.S. Department of Agriculture spent $600 million of that money on virus elimination and disinfection and $200 million in indemnity payments.12

Special Considerations

How Indemnity Is Paid

Indemnity may be paid in the form of cash, or by way of repairs or replacement, depending on the terms of the indemnity agreement. For example, in the case of home insurance, the homeowner pays insurance premiums to the insurance company in exchange for the assurance that the homeowner will be indemnified if the house sustains damage from fire, natural disasters, or other perils specified in the insurance agreement. In the unfortunate event that the home is damaged significantly, the insurance company will be obligated to restore the property to its original state—either through repairs by authorized contractors or reimbursement to the homeowner for expenditures incurred for such repairs.

Indemnity Insurance

Indemnity insurance is a way for a company (or individual) to obtain protection from indemnity claims. This insurance protects the holder from having to pay the full sum of an indemnity, even if the holder is responsible for the cause of the indemnity.

Many companies make indemnity insurance a requirement as lawsuits are common. Everyday examples include malpractice insurance, which is common in medical fields, and errors and omissions insurance (E&O), which protects companies and their employees against claims made by clients and applies to any given industry. Some companies also invest in deferred compensation indemnity insurance, which protects the money that companies expect to receive in the future.

As with any other form of insurance, indemnity insurance covers the costs of an indemnity claim, including, but not limited to, court costs, fees, and settlements. The amount covered by insurance depends on the specific agreement, and the cost of the insurance depends on many factors including the history of indemnity claims.

Property leases also include indemnity clauses. For example, in the case of a rental property, a tenant is typically responsible for damages due to negligence, fines, lawyer fees, and more depending on the agreement. 

Acts of Indemnity

An act of indemnity protects those who have acted illegally from being subject to penalties. This exemption typically applies to public officers, such as police officers or government officials, who are sometimes compelled to commit illegal acts in order to carry out the responsibilities of their jobs. Often, such protection is granted to a group of people who committed an illegal act for the common good, such as the assassination of a known dictator or terrorist leader.

History of Indemnity

Although indemnity agreements have not always had a name, they are not a new concept. Historically, indemnity agreements have served to ensure cooperation between individuals, businesses, and governments.

In 1825, Haiti was forced to pay France what was then called an "independence debt." The payments were intended to cover the losses that French plantation owners "suffered" after losing land and slaves.3 While this form of indemnity was incredibly unjust, it is one example of many historical cases that show the ways indemnity has been applied worldwide.

Another common form of indemnity is the reparations a winning country seeks from a losing country after a war. Depending on the amount and extent of the indemnity due, it can take years and even decades to pay off. One of the most well-known examples is the indemnity Germany paid after its role in World War I. Those reparations were finally paid off in 2010, almost a century after they were put in place.

A letter of intent (LOI) is a document declaring the preliminary commitment of one party to do business with another. The letter outlines the chief terms of a prospective deal. Commonly used in major business transactions, LOIs are similar in content to term sheets. One major difference between the two, though, is that LOIs are presented in letter formats, while term sheets are listicle in nature.

KEY TAKEAWAYS

• A letter of intent is a document declaring the preliminary commitment of one party to do business with another.

• The letter outlines the chief terms of a prospective deal and is commonly used in business transactions.

• LOIs are useful when two parties are initially brought together to hammer out the broad strokes of a deal before resolving the finer points of a transaction.

• Terms included in an LOI are certain stipulations, requirements, timelines, and the parties involved.

• Many LOIs include non-disclosure agreements (NDAs) and no-solicitation provisions.

• Letters of intent are also used outside of the business world in any circumstance where two parties intend to work together or form a deal.

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Letter of Intent (LOI)

Understanding a Letter of Intent (LOI)

LOIs are useful when two parties are initially brought together to hammer out the broad strokes of a deal before the finer points of a transaction are resolved. LOIs often include provisions stating that a deal may only go through if financing has been secured by one or both parties, or that a deal may be squashed if papers are not signed by a certain date.

Since LOIs typically discuss potential points of deals that have yet to be cemented, they are almost universally intended to be non-binding.

LOIs can be iterative in nature. One party may present an LOI, to which the other party may either counter with a tweaked version of that LOI or draft a new document altogether. Ideally, by the time both parties come together to formalize a deal, there will be no surprises on either side of the table.

Many LOIs include non-disclosure agreements (NDAs), which contractually stipulate the components of a deal both parties agree to keep confidential, and which details may be shared publicly. Many LOIs also feature no-solicitation provisions, which forbid one party from poaching the other party's employees.

A letter of intent is usually drafted and signed while negotiations between parties are ongoing so that the final terms of a deal might vary from what was agreed upon in the letter of intent. Due diligence is conducted by both parties before doing business. It is a prudent business practice to complete due diligence before signing a letter of intent.

Purpose of a Letter of Intent (LOI)

Letters of intent may be used by different parties for many purposes. Parties can use an LOI to outline some of the basic, fundamental terms of an agreement before they negotiate and finalize all the fine points and details. Furthermore, the LOI may be used to signal that two parties are negotiating a deal such as a merger or joint venture (JV).

Overall, LOIs aim to achieve the following:

• Clarify which key points of a deal must be negotiated.

• Protect all parties involved in the deal.

• Announce the nature of the deal, such as a joint venture or a merger between two companies.

Applications of a Letter of Intent (LOI)

In the context of business deals, LOIs are typically drafted by a company's legal team, which outlines the details of the intended action. For example, in the merger and acquisitions (M&A) process, LOIs detail whether a firm plans to take over another company with cash or through a stock deal.

Letters of intent also have applications beyond the business world. For example, parents may use them to express the expectations they have for their children in the event both parents die. Although they aren't legal documents like wills, LOIs may be considered by family court judges responsible for legislating what happens to the children under such circumstances.

LOIs are also used by those seeking government grants, and by highly sought-after high school varsity athletes. These individuals frequently draft LOIs to declare their commitments to attend particular colleges or universities.

Networking is the exchange of information and ideas among people with a common profession or special interest, usually in an informal social setting. Networking often begins with a single point of common ground.

Professionals use networking to expand their circles of acquaintances, find out about job opportunities in their fields, and increase their awareness of news and trends in their fields or the greater world.

KEY TAKEAWAYS

• Networking is used by professionals to widen their circles of acquaintances, find out about job opportunities, and increase their awareness of news and trends in their fields.

• Business owners may network to develop relationships with people and companies they may do business with in the future.

• Professional networking platforms provide an online location for people to engage with other professionals, join groups, post blogs, and share information.

• The coronavirus pandemic drove many professionals to network solely online rather than in person.

• Many colleges and universities provide opportunities for alumni to network with one another.

How Networking Works

People generally join networking groups based on a single common point of interest that all members share. The most obvious is a professional affiliation, such as stockbrokers. Still, some people find effective networking opportunities in a college alumni group, a church or synagogue social group, or a private club.

For professionals, the best networking opportunities may occur at trade shows, seminars, and conferences, designed to attract a large crowd of like-minded individuals. Networking helps a professional keep up with current events in the field and develops relationships that may boost future business or employment prospects. Needless to say, it also provides opportunities to help other people find jobs, make connections, and catch up on the news.

Small business owners network to develop relationships with people and companies they may do business with in the future. These connections help them establish rapport and trust among people in their own communities. Successful business networking involves regularly following up with contacts to exchange valuable information that may not be readily available outside the network.

Business owners and entrepreneurs often join their local chamber of commerce to promote their business interests and help others in their community do the same. There are many additional benefits to joining a chamber of commerce, such as receiving deals and discounts from other chamber members, having one's business listed in the chamber directory, and the ability to influence policies related to the area's business and economic activity.

Online Networking

Professional networking platforms such as LinkedIn provide an online location for people to engage with other professionals, join groups, post blogs, and share information. And, of course, they provide a place to post a resume that can be seen by prospective employers, to search for jobs, or to identify job candidates.

These days, a business-to-business (B2B) customer pipeline can be developed almost entirely through the use of a social networking site. Online networking forums allow professionals to demonstrate their knowledge and connect with like-minded people.

LinkedIn is the largest professional network, but there are many others.1 Some cater to particular subsets of people, such as Black Business Women Online. Others have a different focus, such as Meetup, which encourages its members to meet in person off-site or virtually through online video conferences.

The term computer networking refers to linking multiple devices to share information and software resources in an immediate way.

Special Considerations

Given the growing number of networking opportunities available to people looking to start or advance their careers, it's important to take some time to explore your options before committing to a specific networking group.

While it's tempting for a new business owner or someone looking for a dream job to join as many networks as possible, a better strategy is to target your time and efforts toward those groups that best fit your needs and interests. Many networking organizations will host a special meet and greet events that allow potential new members to attend a meeting before becoming a member.

Once you join a networking group, it's important to become a contributing member. Rather than just using the association to further their own goals, people who use networking effectively look to offer something of value to other group members. Networking can help you identify opportunities for collaboration, strategic joint ventures, partnerships, and new areas to expand your business.

How Can I Network Efficiently?

It's important to take some time to explore your options before committing to a specific networking group. While it's tempting for a new business owner or someone looking for a dream job to join as many networks as possible, a better strategy is to target your time and efforts toward those groups that best fit your needs and interests.

Many networking organizations will host a special meet and greet events that allow potential new members to attend a meeting before becoming members. Once you join a networking group, it's important to become a contributing member. Rather than just using the association to further their own goals, people who use networking effectively look to offer something of value to other group members.

Why Is Networking Useful?

Professionals use networking to expand their circles of acquaintances, find out about job opportunities in their fields, and increase their awareness of news and trends in their fields or the greater world. It helps a professional keep up with current events in the field and develops relationships that may boost future business or employment prospects.

Why Should Businesses Network?

Small business owners network to develop relationships with people and companies they may do business with in the future. These connections help them establish rapport and trust among people in their own communities. Successful business networking involves regularly following up with contacts to exchange valuable information that may not be readily available outside the network.

Business owners and entrepreneurs often join their local chamber of commerce to promote their business interests and help others in their community do the same. Networking can help you identify opportunities for collaboration, strategic joint ventures, partnerships, and new areas to expand your business.

What Is Online Networking?

Professional networking platforms such as LinkedIn provide an online location for people to engage with other professionals, join groups, post blogs, and share information. And, of course, they provide a place to post a resume that can be seen by prospective employers, to search for jobs, or to identify job candidates. These days, a business-to-business (B2B) customer pipeline can be developed almost entirely through the use of a social networking site. Online networking forums allow professionals to demonstrate their knowledge and connect with like-minded people.

KEY TAKEAWAYS Porter's Five Forces is a framework for analyzing a company's competitive environment. The number and power of a company's competitive rivals, potential new market entrants, suppliers, customers, and substitute products influence a company's profitability. Five Forces analysis can be used to guide business strategy to increase competitive advantage. 1:44 Porter's Five Forces Understanding Porter's Five Forces Porter's Five Forces is a business analysis model that helps to explain why various industries are able to sustain different levels of profitability. The model was published in Michael E. Porter's book, "Competitive Strategy: Techniques for Analyzing Industries and Competitors" in 1980.1 The Five Forces model is widely used to analyze the industry structure of a company as well as its corporate strategy. Porter identified five undeniable forces that play a part in shaping every market and industry in the world, with some caveats. The five forces are frequently used to measure competition intensity, attractiveness, and profitability of an industry or market.

Porter's five forces are:

1. Competition in the industry

2. Potential of new entrants into the industry

3. Power of suppliers

4. Power of customers

5. Threat of substitute products1

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5 years ago CALCULATE Competition in the Industry The first of the five forces refers to the number of competitors and their ability to undercut a company. The larger the number of competitors, along with the number of equivalent products and services they offer, the lesser the power of a company. Suppliers and buyers seek out a company's competition if they are able to offer a better deal or lower prices. Conversely, when competitive rivalry is low, a company has greater power to charge higher prices and set the terms of deals to achieve higher sales and profits.

Potential of New Entrants Into an Industry A company's power is also affected by the force of new entrants into its market. The less time and money it costs for a competitor to enter a company's market and be an effective competitor, the more an established company's position could be significantly weakened. An industry with strong barriers to entry is ideal for existing companies within that industry since the company would be able to charge higher prices and negotiate better terms.

Power of Suppliers The next factor in the five forces model addresses how easily suppliers can drive up the cost of inputs. It is affected by the number of suppliers of key inputs of a good or service, how unique these inputs are, and how much it would cost a company to switch to another supplier. The fewer suppliers to an industry, the more a company would depend on a supplier. As a result, the supplier has more power and can drive up input costs and push for other advantages in trade. On the other hand, when there are many suppliers or low switching costs between rival suppliers, a company can keep its input costs lower and enhance its profits.

Power of Customers The ability that customers have to drive prices lower or their level of power is one of the five forces. It is affected by how many buyers or customers a company has, how significant each customer is, and how much it would cost a company to find new customers or markets for its output. A smaller and more powerful client base means that each customer has more power to negotiate for lower prices and better deals. A company that has many, smaller, independent customers will have an easier time charging higher prices to increase profitability.

The Five Forces model can help businesses boost profits, but they must continuously monitor any changes in the five forces and adjust their business strategy. Threat of Substitutes The last of the five forces focuses on substitutes. Substitute goods or services that can be used in place of a company's products or services pose a threat. Companies that produce goods or services for which there are no close substitutes will have more power to increase prices and lock in favorable terms. When close substitutes are available, customers will have the option to forgo buying a company's product, and a company's power can be weakened.

Understanding Porter's Five Forces and how they apply to an industry, can enable a company to adjust its business strategy to better use its resources to generate higher earnings for its investors.

Withholding tax is the money an employer deducts from an employee’s gross wages and pays directly to the government. The amount withheld is a credit against the income taxes the employee must pay during the year. Nonresident aliens are also subject to withholding tax—on earned income, as well as on other income such as interest and dividends from the securities of U.S. companies that they own.1

The vast majority of people who are employed in the United States are subject to tax withholding.2

KEY TAKEAWAYS

• Withholding tax is a set amount of income tax that an employer withholds from an employee’s paycheck and pays directly to the government in the employee's name.

• The money taken is a credit against the employee’s annual income tax bill.

• If too much money is withheld, an employee will receive a tax refund; if not enough is withheld, an employee will have additional taxes due.

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Withholding Tax

Understanding Withholding Tax

Tax withholding is a way for the U.S. government to maintain its pay-as-you-go (or pay-as-you-earn) income tax system—taxing at the source of income, rather than trying to collect income tax after wages are earned. 

There are two different types of withholding taxes employed by the Internal Revenue Service (IRS) to ensure that proper tax is withheld in different situations.

U.S. resident withholding tax

The first and more commonly discussed withholding tax is the one on U.S. residents’ personal income, which every employer in the United States must collect. Under the current system, employers collect the withholding tax and remit it directly to the government, with employees paying the remainder when they file a tax return in April each year.3

If too much tax is withheld, it results in a tax refund. However, if not enough tax has been held back, then the individual will owe money to the IRS.4

Generally, you want about 90% of your estimated income taxes withheld and sent to the government.5 This ensures that you never fall behind on income taxes (something that can result in heavy penalties) and that you are not overtaxed throughout the year.

Investors and independent contractors are exempt from withholding taxes but not from income tax—they are required to pay quarterly estimated tax.6 If these classes of taxpayers fall behind, they can become liable to backup withholding, which is a higher rate of tax withholding set at 24%.7

You can easily perform a paycheck checkup using the IRS’s tax withholding estimator.8 This tool helps identify the correct amount of tax withheld from each paycheck to make sure you don’t owe more in April. To use the estimator, you'll need your most recent pay stubs, your most recent income tax return, your estimated income during the current year, and other information.

Nonresident aliens who earn money in the U.S. are also subject to a withholding tax on that income.9

Nonresident withholding tax

The other form of withholding tax is levied against nonresident aliens to ensure that proper taxes are paid on income sources from within the United States.10 A nonresident alien is someone who is foreign-born and has not passed the green card test or a substantial presence test.11

All nonresident aliens must file Form 1040NR if they are engaged in a trade or business in the United States during the year.12 If you are a nonresident alien, there are standard IRS deduction and exemption tables to help you figure out when you should be paying U.S. taxes and which deductions you may be able to claim.13If there is a tax treaty between your country and the United States, that can also affect withholding tax.14

History of Withholding Taxes

Tax withholding first occurred in the United States in 1862 at the order of President Abraham Lincoln to help finance the Civil War. The federal government also implemented excise taxes for the same purpose. Tax withholding and income tax were abolished after the Civil War in 1872.1516

The current system was accompanied by a large tax hike when it was implemented in 1943.15 At the time, it was thought that it would be difficult to collect taxes without getting them from the source. Most employees are subject to withholding taxes when they are hired and fill out a W-4 Form. The form estimates the amount of taxes that will be due.4

The withholding tax is one of two types of payroll taxes. The other type is paid to the government by the employer and is based on an individual employee’s wages. It contributes to funding for Social Security and federal unemployment programs (since the Social Security Act of 1935) as well as Medicare (since 1966).171819

Special Considerations

The majority of U.S. states also have state income taxes and employ tax withholding systems to collect taxes from their residents. States use a combination of the IRS W-4 Form and their own worksheets.

Nine states—Alaska, Florida, Nevada, South Dakota, Tennessee, Texas, Washington, Wyoming, and New Hampshire—do not charge income taxes.20 However, New Hampshire does tax dividends and income from investments, although it voted to gradually phase out this practice by 2027.2122

What Is the Purpose of Withholding Tax?

The purpose of withholding tax is to ensure that employees comfortably pay whatever income tax they owe. It maintains the pay-as-you-go tax collection system in the United States. It fights tax evasion as well as the need to send taxpayers big, unaffordable tax bills at the end of the tax year.

How Much Tax Should You Have Withheld?

The amount of income tax you contribute from each paycheck depends on several factors, including total annual earnings and your filing status.2324

Why Did My Employer Withhold Too Much/Too Little Tax?

Federal tax withholding is based on the information you provide on your W-4 form, which you fill out and give to your employer when you start a job. If you are significantly overpaying or underpaying on income tax, you’ll probably need to fill out this form again with more up-to-date information.

Who Qualifies for Exemption From Withholding?

Employees with no tax liability for the previous year and who expect no tax liability for the current year can use Form W-4 to instruct their employer not to deduct any federal income tax from their wage. This exemption is valid for a calendar year.

The term receivables turnover ratio refers to an accounting measure that quantifies a company's effectiveness in collecting its accounts receivable. This ratio measures how well a company uses and manages the credit it extends to customers and how quickly that short-term debt is collected or is paid. An efficient has a higher accounts receivable turnover ratio while an inefficient company has a lower ratio. This metric is commonly used to compare companies within the same industry to gauge whether they are on par with their competitors.

KEY TAKEAWAYS

• The accounts receivable turnover ratio is an accounting measure used to quantify how efficiently a company is in collecting receivables from its clients.

• The ratio also measures the times that receivables are converted to cash during a certain time period.

• A high ratio may indicate that corporate collection practices are efficient with quality customers who pay their debts quickly.

• A low ratio could be the result of inefficient collection processes, inadequate credit policies, or customers who are not financially viable or creditworthy.

• Investors should be mindful that some companies use total sales rather than net sales to calculate their ratios, which may inflate the results.

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Receivables Turnover Ratio

Understanding Receivables Turnover Ratios

Accounts receivable are effectively interest-free loans that are short-term in nature and are extended by companies to their customers. If a company generates a sale to a client, it could extend terms of 30 or 60 days, meaning the client has 30 to 60 days to pay for the product. The ability to collect on these debts depends on a number of factors, including financial and economic conditions and, more importantly, the client.

The receivables turnover ratio measures the efficiency with which a company is able to collect on its receivables or the credit it extends to customers. The ratio also measures how many times a company's receivables are converted to cash in a certain period of time. The receivables turnover ratio is calculated on an annual, quarterly, or monthly basis.

A company’s receivables turnover ratio should be monitored and tracked to determine if a trend or pattern is developing over time. Companies can also track and correlate the collection of receivables to earnings to measure the impact the company’s credit practices have on profitability.

For investors, it's important to compare the accounts receivable turnover of multiple companies within the same industry to get a sense of the normal or average turnover ratio for that sector. If one company has a much higher receivables turnover ratio than the other, it may be a safer investment. We look at what both high and low turnover ratios mean a little further below.

Accounts receivables appear under the current assets section of a company's balance sheet.

Formula and Calculation of the Receivables Turnover Ratio

Accounts Receivable Turnover Ratio = Net Credit Sales / Average Accounts Receivable

Special Considerations

As noted above, it's always a good idea to compare the receivables turnover ratios of companies that operate within the same industry. So it doesn't make sense to compare the ratio of a small utility company with that of a large oil and gas corporation. That's because there are a number of different factors at play, such as lending terms and the sheer quality of customers who owe money.

When making comparisons, it's ideal to look at businesses that have similar business models. Once again, the results can be skewed if there are glaring differences between the companies being compared. That's because companies of different sizes often have very different capital structures, which can greatly influence turnover calculations, and the same is often true of companies in different industries.

High vs. Low Receivables Turnover Ratio

High Ratios

A high receivables turnover ratio can indicate that a company’s collection of accounts receivable is efficient and that it has a high proportion of quality customers who pay their debts quickly. A high receivables turnover ratio might also indicate that a company operates on a cash basis.

A high ratio can also suggest that a company is conservative when it comes to extending credit to its customers. Conservative credit policies can be beneficial since they may help companies avoid extending credit to customers who may not be able to pay on time.

On the other hand, having too conservative a credit policy may drive away potential customers. These customers may then do business with competitors who can offer and extend them the credit they need. If a company loses clients or suffers slow growth, it may be better off loosening its credit policy to improve sales, even though it might lead to a lower accounts receivable turnover ratio.

Low Ratios

A low receivables turnover ratio isn't a good thing. That's because it may be due to an inadequate collection process, bad credit policies, or customers that are not financially viable or creditworthy. A low turnover ratio typically implies that the company should reassess its credit policies to ensure the timely collection of its receivables. However, if a company with a low ratio improves its collection process, it might lead to an influx of cash from collecting on old credit or receivables.

In some cases, though, low ratios aren't always bad. For example, if the company's distribution division is operating poorly, it might be failing to deliver the correct goods to customers in a timely manner. As a result, customers might delay paying their receivables, which would decrease the company’s receivables turnover ratio.

The asset turnover ratio is another important metric. It measures the value of a company's sales or revenues relative to the value of its assets and indicates how efficiently a company uses its assets to generate revenue. A higher ratio means the company is more efficient. A low asset turnover ratio indicates that the company is using its assets inefficiently to generate sales.

Limitations of the Receivables Turnover Ratio

The receivables turnover ratio is just like any other metric that tries to gauge the efficiency of a business in that it comes with certain limitations that are important for any investor to consider.

For example, some companies use total sales instead of net sales when calculating their turnover ratio. This can actually inflate the results. While this is not always meant to deliberately mislead investors, they should ascertain how a company calculates its ratio. Another option would be to calculate it themselves independently.

Another limitation is that AR varies dramatically throughout the year. This is often the case with seasonal companies. These entities likely have periods with high receivables along with a low turnover ratio and periods when the receivables are fewer and can be more easily managed and collected.

In other words, the ratio may not reflect the company's effectiveness of issuing and collecting credit if an investor chooses a starting and endpoint for calculating the ratio arbitrarily. As such, the beginning and ending values selected when calculating the average accounts receivable should be carefully chosen to accurately reflect the company's performance. Investors could take an average of accounts receivable from each month during a 12-month period to help smooth out any seasonal gaps.

Example of Receivables Turnover Ratio

Let's say Company A had the following financial results for the year:

• Net credit sales of $800,000.

• $64,000 in accounts receivables on Jan. 1 or the beginning of the year.

• $72,000 in accounts receivables on Dec. 31 or at the end of the year.

We can calculate the receivables turnover ratio in the following way:

\begin{aligned} &\text{ACR}=\frac{\$64,000+\$72,000}{2}=\$68,000\\ &\text{ARTR}=\frac{\$800,000}{\$68,000}=11.76\\ &\textbf{where:}\\ &\text{ACR = Average accounts receivable}\\ &\text{ARTR = Accounts receivable turnover ratio}\\ \end{aligned}​ACR=2$64,000+$72,000​=$68,000ARTR=$68,000$800,000​=11.76where:ACR = Average accounts receivableARTR = Accounts receivable turnover ratio​

We can interpret the ratio to mean that Company A collected its receivables 11.76 times on average that year. In other words, the company converted its receivables to cash 11.76 times that year. A company could compare several years to ascertain whether 11.76 is an improvement or an indication of a slower collection process.

A company could also determine the average duration of accounts receivable or the number of days it takes to collect them during the year. In our example above, we would divide 365 by 11.76 to arrive at the average duration. The average accounts receivable turnover in days would be 365 / 11.76, which is 31.04 days.

For Company A, customers on average take 31 days to pay their receivables. If the company had a 30-day payment policy for its customers, the average accounts receivable turnover shows that, on average, customers are paying one day late.

A company could improve its turnover ratio by making changes to its collection process. A company could also offer its customers discounts for paying early. Companies need to know their receivables turnover since it is directly tied to how much cash they have available to pay their short-term liabilities.