Debtors’ turnover ratio to assess operational performance
Perhaps no company can afford to make only cash sales, so giving customers a credit is a necessity. But, it is critical to collect book debts rapidly and within the permitted credit period. Otherwise, the chances of debts becoming unrealizable would increase. What is the efficiency or quality of credit collection of a business? To answer this question, the debtors’ turnover ratio of a company is looked at.
What does it signify?
Debtors’ turnover ratio is also known as Receivables’ Turnover Ratio.
When a business firm sells products on credit, the realization of revenue from such sales is delayed and receivables get created. Cash is realized from these receivables later on. The pace at which these receivables are collected has a direct impact on the liquidity position of the business.
Debtors’ turnover ratio offers insight into the collection and credit policies of a firm. It assesses the effectiveness with which a company’s management manages its accounts receivables.
It determines whether the company’s resources tied up in debtors are reasonable and whether the company has been efficient in converting its debtors into cash. In other words, this ratio measures the rate at which debtors have been turned into cash.
It’s a key indicator of a company’s financial and operational stability, and it can be used to see whether a company is having trouble collecting on credit sales.
The formula for computing debtors’ turnover ratio
Debtors’ turnover ratio represents the ratio of net credit sales to average trade debtors.
This ratio is expressed in times.
Credit sales are the aggregate amount of sales or services rendered by a company to its customers on credit. These are net of any returns and trade discounts.
Accounts receivables include debtors and bills receivables. They represent the amounts standing due from customers for goods sold or services rendered or in respect of contractual obligations.
Since accounts receivable is money owed without interest, businesses that retain accounts receivables are implicitly extending interest-free loans to their customers. If a company makes a sale to a customer, it can offer 30 or 60-day terms, giving the customer 30 to 60 days to pay for the product.
Average accounts receivables are calculated by taking the average of receivables at the beginning and at the end of an accounting year.
While calculating this ratio, it is important to note that provisions for bad and doubtful debts are not deducted from total debtors/accounts receivables in order to avoid the impression that a larger amount of receivables have been collected.
Interpretation
Debtors’ turnover ratio measures the quality of conversion of debtors into cash. It shows the speed at which the money is collected from the debtors.
There is no general norm for the receivables turnover ratio; it usually depends on the industry and other variables that a company is exposed to. To see if a company’s ratio is on par with its competitors, compare it to that of its peers in the same industry.
A low debtors’ turnover ratio reflects sluggish or inefficient credit collection and means that the customers are granted liberal (or generous) credit terms, while a high ratio indicates that collections from customers are made quickly and that the debtors are more liquid.
A high ratio also showcases that the company enjoys a high-quality customer base that is able to re-pay their dues quickly. The higher the ratio, the better is the position.
Receivables’ (Debtors’) Velocity
Debtors’ turnover ratio is used for figuring out the average collection period (or debt collection period). It can be computed as:
However, the average collection period can also be directly calculated as follows:
The average collection period shows the average time (in days) it takes to recover accounts receivable. It gives the average number of days that it takes for a company to translate its accounts receivables into cash. This ratio is also referred to as days sales outstanding (DSO) and is a popular variant of the receivables turnover ratio.
The lower the velocity, the better is the position. A shorter collection period implies prompt payment by debtors whereas a longer collection period implies too liberal credit terms and inefficient performance of credit collection.
Example of debtors’ turnover ratio
For example, if the credit sales are $ 80,000, and average accounts receivable are $ 20,000, receivables’ turnover ratio and debt collection period will be computed as follows:
Receivables’ Turnover Ratio = 80,000 ÷ 20,000 = 4 times
Debt Collection Period = 12 months ÷ 4 = 3 months
This means that, on average, three months credit limit is allowed to the debtors. An increase in the credit period might result in unnecessary blockage of funds and could also increase the possibility of losing money due to debts becoming bad.
Let’s take another example.
Suppose the total sales made by QPR Company for the financial year 2020-21 were $ 12,00,000. Cash sales accounted for 25% of credit sales. Closing debtors amounted to $ 2,00,000 (excess of closing debtors over opening debtors was $ 80,000).
Here,
Total sales = 12,00,000
Cash sales = 25% of credit sales
Total sales = cash sales + credit sales
Cash sales = 25 / 125 x 12,00,000 = 2,40,000
Credit sales = 100/125 x 12,00,000 = 9,60,000
Closing debtors = 2,00,000
Opening debtors = 2,00,000 – 80,000 = 1,20,000
Average debtors = (opening debtors + closing debtors) / 2 = (1,20,000 + 2,00,000) / 2 = 1,60,000
Receivables’ Turnover Ratio = credit sales / average debtors = 9,60,000 / 1,60,000 = 6 times
Average Collection Period = 360 / debtors turnover ratio = 360/6 = 60 days
It indicates that QPR Company converts its receivables into cash 6 times a year and on average, gives 60 days’ credit period to its customers to settle their accounts.
Final thoughts
The debtors’ turnover ratio is a measure that shows how quickly a firm collects outstanding cash balances from its customers during a reporting period. A high ratio is desirable since it indicates that credit collections are frequent and efficient. A low receivables’ turnover ratio may be indicative of a weak collection process, poor credit policies, or customers who are not financially viable or creditworthy.
While a high ratio indicates a conservative credit policy, a low ratio is indicative of liberal credit terms. The credit policy of a firm should be such that it is neither too liberal nor too restrictive. The former will result in more blockages of funds and bad debts while the latter will lead to lower sales which will ultimately reduce profits.
Thanks for reading!
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