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Debtors’ Turnover (ratio)

DEFINITION

An important asset under the current assets is Debtors. This ratio is studied with “Short term solvency ratios”. Debtors’ turnover tells us how many times debtors are converted into cash.

FORMULA

Debtor's Turnover  =

Credit Sales


Average debtors

EXAMPLE

Normally the detailed note of revenue presented on Statement of Comprehensive Income gives us information about the amount of cash and credit sales. However, sales figure presented on face of income statement (as I have done in this example) can be used for calculating this ratio but ideally only credit sales figure should be used.

Why average debtors are used
An important concept to learn is that figures presented on statement of financial position are representing the position on a certain date (e.g. 30 June) instead of representative for the whole year. On the other hand figures presented on Statement of Comprehensive Income are representative of whole year instead of a particular date.

Therefore the issue of incompatibility arises when a ratio includes a figure from statement of comprehensive income and other from statement of financial position. This problem is encountered by using average figure ((opening + closing) / 2) to make balance sheet figure representative of whole year.

Debtor's Turnover  =

7,468,110


1,285,245 + 1,106,185 / 2

Debtor's Turnover  =

6.246 times

Or

Debtor's Turnover  =

365 / 6.246 = 58.44 Days

Data used in calculating ratio is extracted from Hypothetical Financial Statements. (See Hypothetical Financial Statements used in calculation).

MEASUREMENT UNIT

Debtors’ Turnover (ratio) is measured in either Times or Days.
Using the above example, the company has converted its debtors into cash for 6.24 times during the year or debtors are converted into cash in 58.44 days.

INTERPRETATION

How to interpret the ratio

Debtors Turnover tells us how many times management has converted the debtors into cash, in other words how efficiently management is managing its debtors.

Higher debtors’ turnover is good because management is converting the debtors into most liquid assets i.e. cash more quickly and thus will have sufficient cash for meeting its short term obligations. Further it indicates that management has a strict policy of giving credit only to reliable and quickly settling debtors.

Lower debtors’ turnover is bad because management is converting the debtors less quickly into cash. It means working capital is stuck in debtors since they will converted in longer periods, this could for cash problems to management. Lower debtors’ turnover also means that management has to review its credit policy since management is forwarding the credit to such customers who might become bad debt in future. Lower ratio could also mean that current debtors balance might include bad debtors for which management has or is not making provisions.

Users’ needs addressed by the ratio

Creditors are most common users of short term solvency ratios as they are making transactions with the company on short term credit (10 days to 3 months). Creditors are interested to check that company’s current liabilities have sufficient cover of its current assets to meet the obligations as fall due.
Creditors will accept cash as the settlement of their obligation therefore they will check that how efficiently management is converting its other assets (debtors, inventory or investments) into cash.

Management is another user of this ratio. This is linked with the creditworthiness for its creditors as well as measuring managements’ own performance for future improvements.

(You must have an understanding of users’ needs of financial statements; please refer the topic 1- financial statement users for details).

 

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