Receivables / Debtors turnover ratio is one of the key turnover ratios used to analyze the performance of a business. This ratio throws light on the effectiveness of the business in utilizing its working capital blocked in debtors. It also indicates the frequency of conversion of receivables into cash in a given financial year. So, fundamentally, it comments on the liquidity of the receivables of the business.
Receivables turnover ratio has another variant i.e. Average Collection Period which gives a time period in which debtors are converted into cash. Both the ratios indicate the same thing but in different terms. The former is expresses no. of times debtors are converted into cash in a financial year whereas the latter gives no. of days or months in which the debtors are converted into cash.
How to calculate debtors / receivables turnover ratio and Average Collection Period?
In a normal course of business, we understand debtor’s turnover ratio as a relation between credit sales and debtors. The formula to calculate this ratio is very simple.
Formula for Debtor / Receivable Turnover Ratio:
Debtor / Receivable Turnover Ratio = Credit Sales / (Average Debtors + Average Bills Receivables)
Formula for Average Collection Period:
Average Collection Period = (365 Days or 12 Months) / (Debtor / Receivable Turnover Ratio)
Against the simplicity of the formula, the calculation and practical usability of this formula has certain questions. To calculate the ratio, we need credit sales and average receivables over the year. These figures are not readily available in the financial statements of a business. They have to be derived from them along with additional information. The figure of credit sales is still manageable but average receivables are difficult. First practical question would be – what average should be taken? Weekly, Monthly, or Yearly? Needless to say that weekly or monthly average would give better results in terms of correctness of ratio because the preciseness of average receivables increases.
To avoid the situation of non-availability of ratios, debtors and receivable closing balances are used but this practice would have serious questions on the correctness of the ratio. Suppose the debtors are decreased at the end of the financial year due to some seasonal business effect, it would directly improve the ratio which is true at that point of time and not the rest of the year.
Receivables turnover ratio is an absolute figure normally between 2 to 6. A receivable turnover ratio of 2 would give an average collection period of 6 Months (12 Months / 2) and similarly 6 would give 2 Months (12 Months / 6). Meaning is quite clear. A ratio of 2 suggests that the debtor whom credit is extended today, the money is realized in cash after 2 months. Similarly, in case of 6, the money is realized after long 6 months.
For better trade credit management, it is obviously desirable to realize the money as soon as possible because the money which is blocked in the debtors has a cost of interest attached to it whose driver is ‘Time’. If the time to realize the money from debtors is more, the cost is also higher and vice versa. Low debtor’s turnover ratio directly insists on higher working capital requirements and therefore higher interest cost which decreases profits of the firm.
What is desirable – A higher or a lower receivable turnover ratio?
The general rule of life i.e. ‘balance’ is even applicable here. Neither too high nor too low of this ratio is advisable. Let’s see the implications of both the ends.
Very Low Receivable / Debtor’s Turnover Ratio: This is easy to understand. Low receivable turnover ratio means higher collection period. It gives an impression of the wrong choice of debtors or insufficient efforts to collect the cash. Not only will it increase the cost of interest to the company but it will also suggest weak liquidity position of a firm and higher chances of occurring bad debts.
Very High Receivable / Debtor’s Turnover Ratio: It would seems little contradictory to say that even very high receivable turnover ratio is not good. Very high ratio hints of the very tight credit policy of the firm. Undoubtedly, a tight credit policy saves a firm from bad debts and interest cost but they may curb the sales down. By adopting a very tight credit policy, the firm is keeping a big chunk of buyers away from its business and thereby restricting its own business potential by its own policy.
Like temperature of our body has a benchmark of 96 to 98 degree Celsius and that is true for all human beings, there is no such benchmark for this ratio. It depends on the industry practices. A decent way to compare a firm’s trade credit management is to compare its ratios with the industry averages. Ratios of a firm having vicinity to the industry average ratios are considered healthy. Little up and down may result from quality of debtors and liberal policies.
Debtor’s ageing is a very good tool to check the implementation of its credit policy. By debtor’s ageing, debtors are classified in groups of say collection period between 0-2 months, 2-4 months and greater than 4 months. If the firm’s credit policy allows a credit of say 2 months. More than 80-90% of the debtors should fall into the first category of 0-2 months. If, say, 60% lies outside that, it indicates that the credit collection department is not able to collect money from debtors as per the terms and conditions agreed with them. In that case, the management needs a check on them.