Debtors Turnover ratio
The Debtors Turnover Ratio, which is also known as Receivables Turnover Ratio The turnover ratio is a measure of how fast the sales made on credit are turned into cash. This ratio is used to determine how well a company is able to manage and collect on the credit that it has extended to its consumers.
One crucial aspect that must be addressed is the common practise among businesses of reporting total sales rather than net sales, which results in an exaggerated turnover ratio. This is something that must be addressed. Therefore, while calculating this ratio, the only thing that should be taken into account is the net sales of credit.
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 a kind of efficiency ratio that serves as a measure of the financial and operational success of an organisation. It is good to have a high ratio since it demonstrates that the firm is collecting its accounts receivable in an effective manner. A high accounts receivable turnover is also an indication that the firm has a high-quality client base that is capable of paying their bills in a timely manner. A high ratio may also indicate that the corporation has a stringent credit policy, such as a net-20-days policy or even a net-10-days policy.
A low accounts receivable turnover ratio, on the other hand, is a strong indicator that the collection technique used by the organisation is subpar. This might be the result of the firm granting credit terms to clients who are not considered to be creditworthy but who are experiencing financial problems.
In addition, a low ratio may be an indication that the organisation is continuing to prolong its credit policy for an excessive amount of time. This is something that may occasionally be observed in earnings management, when managers would provide unusually lengthy credit policies in order to drive further sales. Because of the time value of money concept, the longer it takes a business to collect on its credit sales, the more money that company effectively loses, or the less valuable the firm’s sales become.
This is because the time value of money decreases as the passage of time progresses. Therefore, a firm is said to be in a precarious financial position when their accounts receivable turnover ratio is either low or falling.
It is beneficial to evaluate a company’s ratio in comparison to that of its rivals or other comparable firms operating in the same market. Instead of just doing an abstract calculation to determine how well a business is doing, a more relevant analysis of the company’s performance may be obtained by comparing the ratios of the company in question to those of other enterprises in a comparable industry. For instance, if the average ratio for the business’s industry is two, a company with a ratio of four, which is not in and of itself a “high” figure, would seem to be doing far better than it really is.