Various ratios are calculated for analysis of financial information, among which turnover ratio is a crucial one. Turnover ratios are calculated to determine how the number of assets and liabilities are created or exchanged in relation to a company's sales. Turnover ratios are also known as efficiency ratios, as these are calculated to determine the efficiency of managing and utilising current assets. In this regard, the account receivable turnover ratio measures the speed and efficiency of collecting money for the sales made in credit. Learn these aspects in detail in this article.
What is the debtors turnover ratio?
In business, sales are made in cash as well as credit. When sales are made in credit, the other party who owes money (to be paid later) is known as the debtor. Due to the sale of goods on credit, there may be a delay in payments, and hence, the money receivable is known as accounts receivable. The debtors turnover ratio is also known as the trade receivables turnover ratio, a financial analysis tool to calculate the number of times the average debtors are converted into cash during the year.
What is the debtors turnover ratio formula?
Debtors turnover ratio is calculated with the help of the following formula:
Debtors or Trade Receivables Turnover Ratio = Net Credit Sales / Average Trade Debtors or Receivables
1. Net credit sale is the total sales made to the customers on a credit basis minus the sales returned by the customers and trade discounts, if any, allowed to them. Or, in simple words,
Net Credit Sales = Total or Gross Credit Sales (-) Sales return (-) Trade discount.
2. Average trade debtors or receivables = (Opening balance of debtors + Closing balance of debtors)/2
Note that debtors include the amount due from the customers and bills receivables.
Now that you know the meaning o f debtors turnover ratio, let us know how to calculate debtors turnover ratio.
To calculate this ratio with the help of formula; first, you need to determine its components, namely, net credit sales and average trade debtors:
- You can determine net credit sales from the Income statement or Profit and Loss Account. From the Profit & Loss A/c, you can find the company's total sales (cash plus credit) made in a given period. You need to calculate the sales made in credit to the customers and deduct the trade discount, if any, allowed to the customer. You also need to keep the sales return in mind. A sales return is the value of goods returned by the customers after the sales.
- Now, you need to find out the number of average accounts receivable by dividing the opening and closing balance of receivables. Receivables or debtors mean the amount that the customer owes to pay to the business. These are the current assets for the business and the collection period of the receivables affect the liquidity of the business. You can find the amount of debtors or receivables from the balance sheet and debtor’s ledger accounts.
- After finding the value or amount of net credit sales and average accounts receivable, put these values in the formula of debtors turnover ratio.
Let us understand the Accounts Receivables Turnover Ratio with the help of this example:
ABC Ltd. has average accounts receivable of Rs. 10,00,000/- and the credit sales made during the year are Rs. 60,00,000. There is a sales return of Rs. 8,00,000. Calculate the trade receivables turnover ratio using the following formula:
Debtors Turnover ratio formula = Net Credit Sales / Average Accounts Receivable
Here, Net Credit Sales = 60,00,000 (-) 8,00,000
Average accounts receivable = 10,00,000
Hence, debtors turnover ratio = 52,00,000/10,00,000 = 5.2
What is the average collection period of debtors, and how to calculate it?
The average collection period of debtors refers to the average number of days taken to collect an account receivable. While the debtors turnover ratio calculates the number of times the debtors or receivable amount is converted into cash during a year, the average collection period tells the average number of days it takes for receiving payment from a debtor. The average collection period is also known as the Receivables (Debtor’s) velocity.
The formula for Receivables (Debtor’s) Velocity or Average Collection Period is as follows:
(i) Average Collection Period = Average Accounts Receivable or Average Debtors / Average Daily Credit Sales
(ii) In simple words, the average collection period is the debtors turnover ratio expressed in terms of several days, and it can be directly calculated with the help of the following formula:
Average Collection Period = 12 months or 52 weeks or 365 days / Debtors Turnover Ratio
From the above example, the Debtors Turnover Ratio comes out to 5.2, and the average accounts receivable are Rs. 10,00,000/-, let us calculate the average collection period for a year with 365 days.
Formula for average collection period:
= Average accounts receivables / Average daily credit sales
Here, average accounts receivable = Rs. 10,00,000/-
Average daily credit sales = 52,00,000/365 = Rs. 14,247 (round off)
Hence, average collection period = 10,00,000/14,247 = 70.19 days
However, we can also directly calculate the average collection period with the debtors turnover ratio as follows:
Average collection period = 365/5.2 = 70.19 days
How does the Accounts Receivable Turnover Ratio help in financial analysis?
Financial analysis is important for drawing meaningful conclusions from the business's financial statements, be it income statement or profit and loss account and balance sheet. Ratios are an important tool for financial analysis. There are different types of ratios such as:
- Liquidity ratio
- Leverage or solvency ratio
- Efficiency or turnover ratio
- Profitability ratio
This ratio is helpful in financial analysis as the following interpretations can be drawn from it:
(i) Accounts receivable turnover ratio or debtors turnover ratio is an efficiency ratio. This ratio tells whether the company can manage and collect money from receivables or debtors efficiently and regularly. If the accounts receivable turnover ratio of the company is high, it shows that the collections are made quickly, and the amount of receivables or debtors is converted into cash or the payments are received rapidly. It also says that the company follows a short-term credit policy, and there are fewer days between the date of sale and receiving money.
(ii) On the other hand, if the debtors turnover ratio of the company is low, it shows that the company follows a long-term credit policy and suggests that the company's receivables are not managed efficiently. A low debtors turnover ratio is the indicator that the company's liquidity position might also not be good as it takes a longer time to garner the cash.
(iii) The accounts receivable turnover ratio of the company can be compared with the industry ratio. The comparison of the ratios of a company with its competitors helps analyse the performance of a company and the industry as a whole. If the average ratio for the industry is low and the company's ratio is slightly higher than the industry ratio, then the company can be identified to be performing better, even if the ratio of the company seen separately is low.
Importance of accounts receivable turnover ratio
- It is a liquidity ratio and high accounts receivable turnover ratio which indicates better liquidity. Therefore, it helps the creditors decide whether the organisation will be able to honour their payments on the due date.
- With the help of this ratio, the employees and the lenders can assess the organisation's financial position.
- It also helps the sales managers to estimate the future sales figure.
- It is also helpful in determining the credit policy of the organisation. The management can decide to provide a short period of credit to its customers to improve the organisation's liquidity.
- The accounts receivable turnover ratio is also used in financial modelling. It is used in preparing budget forecasts and tentative balance sheet figures. The accounts receivable or sundry debtors figure can be estimated with the help of this ratio.
Is there any difference between the assets turnover ratio and the debtors turnover ratio?
Yes, these are two different ratios. The asset turnover ratio is used to measure the efficient utilisation of the company’s assets for generating revenue. In contrast, the debtors turnover ratio assesses the company’s ability to collect the money from its customers frequently and regularly.
What are the limitations of the accounts receivable turnover ratio?
Although the accounts receivable turnover ratio is a good tool and indicator for measuring and analysing an organisation’s financial performance, it has some limitations. Apart from the company ratio, other factors and industry ratio should also be given adequate weightage and importance for decision making and policy framing. Some of the issues that can prevail in the organisation, even if the accounts receivable turnover ratio is high, are:
1. The ratios are interrelated. Therefore, relying only on the company ratio can lead to wrong interpretations. Consequently, it is better to compare the company ratio with competitors and industry ratio.
2. If the ratio is too high compared to the overall industry ratio, it indicates that the company follows a concise credit policy. It only allows a credit period to the high-value customers. This type of credit policy can be non-beneficial for the organisation in the long run as the competitors can take advantage and attract more customers with a flexible and liberal credit policy.
3. If the company uses the total cash and credit sales to calculate the ratio and the amount of cash sales is more than the credit sales, then the debtors turnover ratio will rise, which can be a misleading factor for the various stakeholders.
4. The low receivable turnover ratio does not always mean poor receivable management. It can also be due to other reasons such as deliberate delay or default in payments by the customer due to delivery of defective or damaged products by the company and higher sales return.
Also Read: Double Entry System of Accounting
The debtors turnover ratio or trade receivable turnover ratio can help in understanding the performance and financial position of the company. Through this, the current business position can be determined along with the company ratio which can be compared with other industry ratios. The ratios are interdependent and therefore other parameters should also be considered for the evaluation of debtors and the company's collection period. However, with the help of this ratio, the small and medium-sized organization can decide and frame the credit policy for its customers.
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