Debtors Turnover Ratio - Meaning, Formula, Calculation

In the world of finance, liquidity plays a vital role in determining a company’s ability to survive and grow. A key metric that helps assess this efficiency is the Debtors Turnover Ratio. It indicates how frequently a company collects its outstanding credit over a specific period and also offers insights into its credit policies.

In this article, we’ll explore the debtors turnover ratio meaning, along with its formula, calculation, and key interpretations in detail.

What is Debtors Turnover Ratio?

The Debtors Turnover Ratio, also known as the Accounts Receivables Turnover Ratio, measures how efficiently a company collects its average outstanding receivables over a specific period. It indicates how frequently the company converts its credit sales into cash, reflecting the effectiveness of its credit and collection policies.

This accounting ratio helps quantify how well a business manages and recovers payments from its clients. A good understanding of this ratio enables companies to optimize their credit policies, reduce bad debts, and maintain a strong financial position in a competitive market.

How to Calculate Debtors Turnover Ratio

Now that we understand the concept, let’s explore the debtor's turnover ratio formula along with an example to understand how it works:

Debtors Turnover Ratio Formula

Debtors Turnover Ratio = Net Credit Sales / Average Accounts Receivable

• Here, the ‘net credit sales’ indicates the total revenue that the company has earned only through credit transactions. To arrive at the net credit sales amount, we need to deduct adjustments like sales discounts or returns from gross credit sales.

• Here, the ‘average accounts receivable’ indicates the average amount of outstanding customer invoices a company has over a specific period. It is typically determined by taking the average of a company’s opening and closing accounts receivable balances. 

Debtor Turnover Ratio Example

Let us understand the debtors turnover ratio with the help of an example given below.

ABC Ltd., a manufacturing company, recorded gross credit sales of Rs 22,50,000 during the year with sales return and discounts amounting to Rs 1,50,000. The company’s opening and closing accounts receivable were Rs 2,40,000 and Rs 3,60,000, respectively. 

From the above information, we obtain the following values: 

Step 1: Net Credit Sales = Rs 22,50,000 - Rs 1,50,000 = Rs 21,00,000

Step 2: Average Accounts Receivables = (Rs 2,40,000 + Rs 3,60,000) / 2 = Rs 3,00,000

Step 3: Debtors Turnover Ratio = Rs 21,00,000 / Rs 3,00,000 = 7 times

This means that ABC Ltd. collects its receivables seven times a year, aligning with the industry standard. 

What Is the Ideal Debtors Turnover Ratio?

Generally, there is no ideal debtors turnover ratio as it depends on various industries and their cash flow patterns. 

However, when we speak about a good debtors turnover ratio, we have the high and low ratio which indicates different liquid positions of the company. Let us look at them now. 

High Ratio

A high accounts receivable ratio indicates efficient collections and reliable customers who pay quickly. It may also show that the company operates largely on a cash basis or follows a strict credit policy to minimize bad debts. 

While restrictive credit policies reduce risks, they can also drive potential customers to go to our competitors who offer more flexible credit terms. Therefore, finding the right balance is the key to maintaining growth while ensuring timely collections. 

Low Ratio

A low accounts receivable ratio indicates inefficiency in the receivables collection process. It tells us that the company is slow in collecting payments from its credit customers, leading to cash flow issues and financial instability. 

Delayed collections, loose credit policies, and high unrecoverable payments are some of the main factors that are responsible for a low debtors turnover ratio. On the other hand, having a liberal credit policy would boost additional sales over the long run.

Factors Affecting Debtors Turnover Ratio

The debtors turnover ratio is influenced by various internal and external factors that impact how efficiently a company collects payments from its customers. Below are the major factors that affect the ratio. 

1) Credit Policy: 

A restrictive/strict credit policy usually leads to a higher debtors turnover ratio as credit payments are collected quickly. Whereas a liberal/lenient credit policy results in a lower ratio because of late payments. 

2) Efficient Collection: 

Companies that have strong credit collection strategies will have a higher debtors turnover ratio and vice versa. These include various strategies like proactive collection efforts, timely follow-ups, efficient billing systems, etc., that can smooth the credit collection process. 

3) Industry Type:

 Businesses with frequent and small transactions like retail, FMCG, etc., will usually have a higher debtors turnover ratio as customers have to pay quickly due to the small credit period. On the other hand, companies with longer sales cycles, like manufacturing, construction, etc., will typically have a lower ratio due to extended credit periods.  

4) Customer Creditworthiness: 

Serving financially stable clients will ensure timely payments as well as a high debtors turnover ratio. But, extending your credit to high-risk customers can lead to payment delays which results in a lower ratio.

5) Competitor Credit Policies:

 If the company's competitors are more flexible and liberal, customers might choose the competitors over your company. This will force the company to extend its credit period to match its competitors, which will lower the debtors turnover ratio.

Importance of Debtors Turnover Ratio

Understanding the debtors turnover ratio is crucial in order to assess various things regarding the company. Here, the significance of the ratio is given below.

Collection Efficiency: 

A debtors turnover ratio helps a company to understand how quickly and efficiently is it able to collect money from its customers who buy on credit.

A high debtors turnover ratio means that the company is collecting payments quickly and regularly, whereas a low debtors turnover ratio suggests that the company is slow in collecting payments. 

Credit Policy Effectiveness:

A credit policy refers to the rules a business sets for giving customers extra time to pay for purchases instead of paying upfront in cash. 

If a company has a very high debtors turnover ratio, it could be a sign of having a restricted/strict credit policy. Whereas, if the ratio is very low, it could indicate having a liberal/loose credit policy.

Liquidity Management: 

Liquidity refers to a company’s ability to meet its short-term obligations. If the company has a high debtors turnover ratio, it could indicate that the company has more adequate cash available to cover its day-to-day expenses. On the other hand, a low ratio indicates that customers take a long time to pay, which can lead to cash flow problems. 

Bad Debts Risk: 

If the customers are delaying their payments or fail to pay at all, the company may face bad debts, where the money is unlikely to be recovered. 

By maintaining a high debtors turnover ratio, a company can reduce the chances of bad debts as the customers are making prompt payments within the credit period. But, a low ratio will tell us that the company might come under financial distress as too much money is stuck in unpaid invoices. 

Influences Creditworthiness: 

Lenders, including the best banks and financial institutions, use the debtors turnover ratio as a key metric to assess a company’s financial stability.
A high ratio makes the company a low-risk borrower from a lender’s perspective, suggesting that if a company efficiently recovers money from customers, it’s more likely to repay its debts on time. Conversely, a company with a low ratio might face cash flow issues, making it difficult to repay loans.

Limitations of Debtors Turnover Ratio

While the debtors turnover ratio is a useful metric for assessing a company’s efficiency in collecting receivables, it also comes with certain limitations. Let us look at some of them now. 

Industry Differences: 

As various sectors have different sales cycles and credit policies, it becomes unfair and difficult to compare the ratios between businesses directly. So, instead of comparing the ratio across industries, businesses should compare their ratio with industry benchmarks or past performance to get a fair idea about industry analysis. 

Seasonal Variations: 

The fluctuations in the sales of a business throughout the year due to seasonality will make it difficult to get a clear picture of the company’s credit management. Therefore, businesses should analyze the ratio over multiple periods rather than relying on a single-period calculation to assess their credit efficiency. 

Doesn't Reflect Profitability or Cash Flow

The debtors turnover ratio will only measure t he efficiency with which the company is able to collect its credit, and fails to project the profitability and cash flow management. Suppose, a company having a high debtors turnover ratio might still not be profitable due to low profit margins.

Service-based businesses: 

Many service-based companies will find this ratio less useful as the majority of their payments are subscription-based or due upon receipt/immediate payments. Hence, the ratio may appear to be higher because of advance payments, but this does not reflect actual credit management accuracy. 

How Can Companies Improve Debtors Turnover Ratio?

Below, we have listed out the major and effective strategies that companies can use in order to improve their debtor turnover ratio and speed up collections. 

• Customer relationships: Building strong customer relationships encourages timely payments. When customers trust the company, they're more likely to pay on time, helping improve collection speed.

• Credit policy: Credit sales should be carefully executed after assessing a customer's creditworthiness. By evaluating a customer's financial stability and payment history, companies can determine their eligibility for credit and establish an appropriate credit period.

• Discounts: The company can offer discounts for early payments to encourage credit customers to settle their dues faster, allowing them to save money on their purchases, and leading to a more efficient collection process.

Conclusion

Improving the debtors turnover ratio is not just about collecting payments faster, it is also about creating a structured and efficient credit management system. It is the delicate balance between offering credit to boost sales and ensuring timely collections to maintain liquidity. Accordingly, a well-maintained ratio will ensure smooth cash flow and reduce bad debts whereas adopting better credit policies, using automation tools, discounts, and penalties will ensure a high turnover ratio. 

Ultimately, the goal is not just to improve the ratio but to create a good credit management system that ensures liquidity and profitability for long-term success!