Receivables (Debtors) Turnover Ratio and Average Collection Period
The second major activity ratio is the receivables or debtors turnover ratio. Allied and closely related to this is the average collection period. It shows how quickly receivables or debtors are converted into cash. In other words, the debtors turnover ratio is a test of the liquidity of the debtors of a firm.
The liquidity of a firm’s receivables can be examined in two ways: (i) debtors/receivables turnover; (ii) average collection period. The debtors turnover shows the relationship between credit sales and debtors of a firm. It can be calculated in two ways,
This approach requires two types of data. First, credit sales, which may not be readily available to the analyst. Similarly, the computation of the figure of average debtors and bills receivable involves practical difficulties. In theory, these figures should be measured, as in the case of average inventory, on the basis of the monthly average. Since this type of information is not likely to be available to the analyst, the alternative is to use the average of the opening and closing balances of debtors and bills receivable.
To avoid the difficulty arising out of the non-availability of information in respect of credit sales and average debtors and bills receivable, the alternative method is to calculate the debtors turnover in terms of the relationship between total sales and closing balance of debtors. Thus,
The first approach to the computation of the debtors turnover is superior in that the question of the speed of conversion of sales into cash arises only in the case of credit sales. The effect of adopting the second approach would be to inflate the receivables turnover ratio and deflate the collection period.
The second type of ratio for measuring the liquidity of a firm’s debtors is the average collection period. This is in fact, interrelated with, and dependent upon, the receivables turnover ratio. It is calculated dividing the days in a year by the debtors turnover. Thus,