Debtors Turnover ratio

The Debtors Turnover Ratio also called as Receivables Turnover Ratio shows how quickly the credit sales are converted into the cash. This ratio measures the efficiency of a firm in managing and collecting the credit issued to the customers.

One important thing that needs to be taken care of is, generally the companies use total sales in the place of net sales, which gives an inflated turnover ratio. Thus, while calculating this ratio, only the net credit sales is to be taken into consideration.

Ideally, a company compares its debtors turnover ratio with the companies that have similar business operations and revenue and lie within the same industry The formula to compute Debtors Turnover Ratio is:

Debtors Turnover Ratio = Net Credit Sales/Average Account Receivable.

Where, Average Account Receivable includes trade debtors and bill receivables.

Higher the Debtors turnover ratio, better is the credit management of the firm.

Example: Suppose a firm has total sales of Rs 5,00,00 out of which the credit sales are Rs 2,50,000. The opening balance of account receivables is Rs 2,00,000 and the closing balance at the end of financial year is Rs 1,00,000. The debtors turnover ratio will be:

Debtors Turnover Ratio = 2,50,000/1,50,000 = 1.67 times

Credit sales = 2,50,000
Average Account Receivables = (2,00,000+1,00,000) /2 = 1,50,000

Interpretation of Accounts Receivable Turnover Ratio

The accounts receivable turnover ratio is an efficiency ratio and is an indicator of a company’s financial and operational performance. A high ratio is desirable, as it indicates that the company’s collection of accounts receivable is efficient. A high accounts receivable turnover also indicates that the company enjoys a high-quality customer base that is able to pay their debts quickly. Also, a high ratio can suggest that the company follows a conservative credit policy such as net-20-days or even a net-10-days policy.

On the other hand, a low accounts receivable turnover ratio suggests that the company’s collection process is poor. This can be due to the company extending credit terms to non-creditworthy customers who experience financial difficulties.

Additionally, a low ratio can indicate that the company is extending its credit policy for too long. This can sometimes be seen in earnings management where managers offer a very long credit policy to generate additional sales. Due to the time value of money principle, the longer a company takes to collect on its credit sales, the more money a company effectively loses, or the less valuable the company’s sales. Therefore, a low or declining accounts receivable turnover ratio is considered detrimental to a company.

It’s useful to compare a company’s ratio to that of its competitors or similar companies within its industry. Looking at a company’s ratio, relative to that of similar firms, will provide a more meaningful analysis of the company’s performance rather than just an abstract calculation. For example, a company with a ratio of four, not inherently a “high” number, will appear to be performing considerably better if the average ratio for its industry is two.