Table of contents
- An Introduction: What is the Debtors Turnover Ratio?
- Debtors Turnover Ratio – Formula and Calculations
- Outlining the Best Examples of Debtors Turnover Ratio
- Debtors Turnover Ratio Limitations – What Are They?
- Wrapping up
Managing the working capital of the company becomes a foundation step toward success. That’s where the discussion of the debtors turnover ratio comes into being. The debtors turnover ratio is an important metric that determines the ability of the company to convert sales into cash. So, what is debtors turnover ratio? This guide takes you through the meaning, formula, and examples of debtors turnover ratio. Let’s find out more about the ratio from the points below, where you can learn further about the ratio, its definition, meaning, examples, and other details.
An Introduction: What is the Debtors Turnover Ratio?
Different ratios are taken into consideration for financial information analysis. Among all the factors, the turnover ratio is the most crucial one. The ratio is also called the efficiency ratio since it is calculated to assess the efficacy of managing or using the most current assets. So, the AR or accounts receivable turnover ratio evaluates the efficiency and speed of collecting money for sales.
Sales in businesses are made in the form of cash and credits. For sales made in credit, the one who is to be paid later (who owes the money) is the debtor. There might be payment delays owing to the sale of goods. So, the amount received is better termed as the accounts receivable. In that respect, the debtors turnover ratio is the trade receivables turnover ratio. The financial analysis tool calculates how many average debtors get converted into cash throughout one fiscal year.
You can calculate the value of average debtors with the following average debtors’ formula:
Average debtors’ formula = [Debtor’s opening balance + closing balance] / 2
Suppose the turnover ratio is high. In such circumstances, the collection methodologies remain effective. It also indicates that customers are serious about their debt payments and make them on time. However, when the debtor turnover ratio is low, the organisation may experience a slower or ineffective collection procedure. In such cases, the firm might have trouble with inaccurate credit policies. Thus, investors need to be doubly sure of the total sales.
Companies can use accounts receivable loans for users since they come with no interest. Another benefit is that they are short-term. Thus, a company can extend the time for paying 30-60 days.
With the debtors turnover ratio, a company can determine its efficacy of collecting receivables or extending to a consumer. Besides, it also evaluates specific times the receivables are changed to cash for a company. The ratio is calculated on a monthly, annual, or quarterly basis.
The following are how a company benefits from the debtors turnover ratio:
Improves a Company’s Capital Investment Decisions
If a company can swiftly convert its receivable balances into cash, it gains the capability to calculate funds for future initiatives.
Assesses the Company in Collecting Credit Sales
Another advantage of the debtors turnover ratio lies in the accuracy and speed associated with collecting the credit sales. The quicker processing of balances enables the company to acquire capital more speedily.
To evaluate the efficiency of an organisation’s credit and collection procedures, you need to calculate the debtors’ velocity. The debtors’ velocity formula is:
Debtors Velocity Formula = Total Sales / Balance Of Debtors
Better Process to Evaluate Credits of Clients
Another significant benefit is the convenience with which the company assesses the creditworthiness of its clients. Additionally, a slower turnover allows for understanding different aspects of determining clients’ insolvency and the reasons behind delayed payments.
Better Manages Cashflow
The ratio helps the company manage its cash flow. The fact is that effective collection of accounts receivable helps the healthy inflow, which meets operational costs, allows for growth, and manages financial obligations.
Helps the Company Gain a Competitive Edge
A company can determine its competitiveness while evaluating financial ratios. The company can evaluate its position in the industry and make decisions accordingly.
Evaluate the Company’s Financial Health
With the debtor turnover ratio, a company can better understand its financial health. It helps the organisation collect accounts receivable, thereby understanding its financial health. An effective debtor turnover ratio helps manage finance besides raising concerns about creditworthiness, liquidity, or other cash flow issues.
Debtors Turnover Ratio – Formula and Calculations
You can calculate the ratio by dividing the net credit sales by the average AR or accounts receivable. Presented below is the debtors turnover ratio’s formula:
Debtors Turnover ratio
= Net Credit Sales / Average Accounts Receivable
Understanding the Calculation –
Mentioned below are the effective steps to calculate the debtors turnover ratio:
Step 1: Determining the credit sales
Now, what do you mean by the net credit sales? Simply put, it is achieved once you subtract the sales returns and allowances from the credit sales. The following is the calculation for net credit sales:
Net Credit Sales are equal to the total credit sales minus sales returns and allowances
Step 2: Evaluating the accounts receivable on average
You can easily calculate the average AR by adding the first and last accounts receivable balances. You must divide the amount by 2.
Average Accounts Receivable = [The beginning and ending Accounts Receivable] divided by 2
Step 3: Calculating the Debtors Turnover Ratio
So, in the last step, you need to calculate the debtors turnover ratio. You can apply the formula of the debtors turnover ratio.
Debtors Turnover Ratio =
The net credit sales / (divided by) the average accounts receivable
Note: You need to calculate the debtor days. If you are curious to know how to calculate debtor days, the following is the formula:
Debtor days = [AR/annual credit sales] x 365
Outlining the Best Examples of Debtors Turnover Ratio
Suppose a company XYZ had net credit sales of ₹4,00,000 during its first year.
The AR or accounts receivable balance was ₹90,000 in the initial stage. The amount increased to ₹80,000 at the year’s end.
Average Accounts Receivable =
[Beginning + Ending Accounts Receivable] / 2
= (90,000 + 80,000) divided by 2
Debtors Turnover Ratio =
Net Credit Sales (divided by) / the Average Accounts Receivable
So, the total amount is:
₹4,00,000 / ₹90,000
Debtors Turnover Ratio Limitations – What Are They?
You may calculate the debtor turnover ratio. For this reason, you can divide the amount by the debtors’ balance in case there are no closing or opening balances of the debtors. However, it has certain downsides. Here are the limitations:
- The ratio only focuses on the efficiency of the accounts receivable.
- A low ratio might not be a huge concern in industries where revenue doesn’t come in a constant stream and vice-versa.
- The accounts receivable may change throughout the year, so the beginning and ending values are considered to get an average.
So, you can keep the above things in mind in case you are new in this entrepreneurship industry. You have discovered everything about the debtors turnover ratio formula, its meaning, formula, calculations, examples, and limitations.
The Debtors Turnover Ratio is a financial metric that measures how efficiently a business manages its receivables or accounts receivable. Moreover, it indicates how many times, on average, a company collects payments from its debtors or customers within a specific period.
A lower debtor turnover ratio may imply that the company is taking more time to collect payments from its customers. This could be a signal of lenient credit policies or difficulties in collecting debts, which might affect the company’s cash flow and liquidity.
Companies should ideally evaluate their debtors’ Turnover Ratio from time to time, such as on a quarterly or annual basis. This helps in monitoring changes over time and allows for timely adjustments to credit and collection strategies if needed.
There are a number of factors that can impact the debtor turnover ratio, including changes in credit policies, economic conditions affecting customer payment capabilities, and the industry’s nature. Monitoring these factors is essential to understanding shifts in the ratio.