BAJAJ BROKING
March 13, 2025
9 mins read
The debtors turnover ratio is an important financial metric that represents the efficiency of outstanding receivable collection for a business. Working capital management and consistent cash inflows are the lifeblood for a business. The debtors turnover ratio is also called the accounts receivable turnover ratio and it measures how frequently revenues are collected from credit customers in a financial year. Since this ratio quantifies the efficiency of revenue collection, it is also referred to as the efficiency ratio.
Suppose there is an FMCG distributor who sells goods to retailers. In the FMCG business, retailers usually pay the distributors within 15 - 45 days which is known as the credit period. Therefore, during those 15 - 45 days, the distributor has to arrange cash for his day-to-day business operations. Such scenarios highlight the importance of cash and working capital management in business. In business operations, goods and services are usually sold on credit or cash by a company. The customer to whom goods and services are sold on credit is called the “debtor” because the customer owes a particular amount to the company. This results in delayed collection of revenue for the company that can impact its daily operations. This ratio is an indication of a company’s ability to convert its outstanding balances of clients to cash, thereby managing its working capital efficiently. A company that can manage its working capital efficiently has a higher value of debtors turnover ratio which indicates it can convert debtors into cash more number of times in a particular financial year. A low value of this ratio indicates that a company is not able to collect outstanding balances from its debtors very efficiently and this may hamper its business operations. Within a particular industry, the debtors turnover ratio is one of the important financial parameters used to evaluate companies and its peers.
Computing the debtors turnover ratio involves a series of steps after which the value of the ratio can be arrived at. Following are the key steps to be followed in debtors turnover ratio calculation -
Find the net credit sales
Step 1 is to determine the gross credit sales for the company. Net credit sales excludes all transactions that have been paid by cash. Also, discounts, returns, and allowances have to be subtracted from the total gross credit sales to arrive at the net credit sales. For this calculation, a consistent time period needs to be followed. So, net credit sales can be for a particular quarter, half, or year. The net credit sales becomes the numerator of the formula.
Determine the average accounts receivable
After calculating the net credit sales, the amount owed by the customers to the company must be taken into account. This can be calculated through the average accounts receivable, the denominator of the formula. The average accounts receivable is determined by adding the accounts receivable at the start and end of the time period and then dividing the sum by two.
Plug in the values into the formula
The formula for the debtors turnover ratio is given by
Debtors turnover ratio = Net credit salesAverage Accounts Receivable
The debtors turnover ratio can be calculated by substituting the values obtained in the previous steps.
The debtors turnover ratio offers the following benefits for a company -
Improves a company’s creditworthiness
A high debtors turnover ratio indicates the ability of a business to quickly convert its outstanding payments to cash which is a result of trust and brand name in the industry. This helps a business secure business funding with more favorable interest rates from borrowing institutions.
Provides a measure of revenue collection efficiency
This ratio helps a business evaluate its own performance in working capital management and provides a strong quantifiable measure of collection efficiency. A business can calculate the figures for a particular quarter or a year and then target year-on-year improvements in the accounts receivable ratio.
Helps in peer comparison
In a particular industry, a company can compare itself with its peers and benchmark figures on the basis of the debtors turnover ratio. If a company wants to become a major player by beating its rivals, it has to improve its revenue collection efficiency.
Helps evaluate prospective customers
While targeting new markets, a business has to look for new customers and clients. Debtors turnover ratio is a key metric that a company can use to judge whether an entity is worthy enough to be its customer. If the prospective customer has a low debtors turnover ratio, then it is a red flag because it indicates that the prospective customer is inefficient in managing its working capital. This will result in delayed payments to the business. So, the business would not want to consider those prospective customers that do not meet a threshold of the ratio.
Enables capital investment estimations
When a business can quickly turn around the outstanding balances into cash, it helps the business project the cash flows for the future. This subsequently enables a business to plan its capital investments and research and development costs in the future.
The usual debtors turnover ratio may vary across sectors but within a particular sector, a high value of this ratio represents that a company is able to collect its outstanding payments from customers quickly and more frequently. This also indicates that for the business, a major share of customers pay off their amounts quickly. This is a measure of the quality of customers for a business. Also, a higher value for the debtors turnover ratio points towards the fact that the business may be dealing with its customers majorly on a cash basis. This highlights the strength and reputation of the business. When the debtors turnover ratio is high, it also means that the business is very careful in extending credit, has a conservative credit policy, and deals only with those customers that can pay on time. It represents a stringent customer evaluation policy which is a strength of a business.
On the other hand, a low debtors turnover ratio is, prima facie, a red flag because it means that the business cannot realize its outstanding revenues quickly from customers. This is a symptom of other deeply-rooted issues such as low creditworthiness of customers, lenient credit policy and evaluation procedures, and lesser effort in collection. In a particular industry, if a business has a lower value than the benchmark, it must reassess its credit policies, stop doing business with customers who do not pay on time consistently, and increase the share of customers who do business on cash.
There could be several factors that affect the debtors turnover ratio as mentioned below -
Nature of the industry
The debtors turnover ratio for the FMCG sector will be more than that for CAPEX-heavy industries such as construction. This is because goods are sold in a matter of days or months in the FMCG sector whereas a construction project may take several years to get completed.
Nature of the customer
Customer-specific factors also affect a company’s debtors turnover ratio because some customers might pay on time whereas others do not. There could be a case where the customer is already a well-established name in the industry and therefore expects a longer credit period from a business. Whereas, a customer who is trying to establish itself may clear dues on time to avoid a bad reputation.
Business seasonality
Agriculture is a highly seasonal business because certain crops can grow only in either the Kharif or the Rabi season. Businesses in such seasonal industries can expect longer days of credit outstanding in certain periods and shorter days in remaining periods in a year.
Economy
If the economy is experiencing problems such as recession and low consumption, business also experiences a slowdown due to which the outstanding balances may not be paid on time.
Credit policy
Depending on the credit policies of a customer, the debtors turnover ratio can see a range of values. For instance, businesses with a lot of customers having a 30-day payment policy will have a different debtors turnover ratio compared to those with customers having a 15-day payment policy.
Just like other metrics, the debtors turnover ratio also suffers from limitations some of which are mentioned below -
Dependence on average accounts receivable
The dependence on average accounts receivable is doubtful because there can be a case where the beginning and ending values could be the same along with huge fluctuations within the period. In such cases, the average accounts receivable does not provide a true picture of the accounts receivable for a business, thus affecting the debtors turnover ratio.
Accuracy in calculations
In some cases, a business may consider gross sales instead of net sales in the formula that inflates the numerator and ultimately the value of the ratio. This presents an inaccurate view of the revenue collection efficiency for a business when in reality, the value could be lower than what has been calculated.
Denotes collection efficiency at a particular time
The debtors turnover ratio indicates the collection efficiency for a business at a specific time and nowhere does it provide an overview of the collection efficiency for a period. To get a general sense of the working capital management for a business, the ratio needs to be recalculated for different periods multiple times based on which an uptrend or a downtrend can be observed.
Name of the ratio | Formula | Importance | Additional notes |
Debtors turnover ratio | Debtors turnover ratio = Net credit salesAverage Accounts Receivable | Denotes the revenue collection efficiency for a business. | Also called accounts receivable ratio or efficiency ratio |
Current ratio | Current ratio = Current assetsCurrent liabilities | Shows whether a business can meet its short-term obligations through its short-term assets | It is the most lenient of all liquidity ratios as it considers all current assets |
Quick ratio = Cash + Accounts receivable + Marketable securitiesCurrent liabilities | Shows whether a business can meet short-term obligations through specific short-term assets | More stringent than the current ratio as only three types of current assets are considered | |
Cash ratio | Cash ratio = Cash + Marketable securitiesCurrent liabilities | Shows whether a business can meet short-term obligations through specific short-term assets | The most stringent of all liquidity ratios as it considers only cash and marketable securities |
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The debtors turnover ratio and the receivables turnover ratio essentially refer to a measure of the revenue collection efficiency for a company. So, they are practically the same.
A high debtors turnover ratio indicates more robust outstanding collection processes and high quality of customers for a business.
This can be done by changing the credit policy, ceasing business with clients who do not pay on time, and implementing a robust evaluation policy while prospecting new clients.
The debtors turnover ratio suffers from several limitations such as business seasonality, calculation inaccuracies, and presenting a picture at a point of time.
Yes, it is relevant for all industries. But the benchmark values may vary across industries depending on the nature of industries.
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