Efficiency ratios - debtor days (debtors' collection period)
Debtors are customers, who owe the firm money for the product they have bought on credit. Debtors should be kept as low as possible because they have the firm's products, but are yet to pay for them - a double bonus! However, it is tempting for the firm to increase sales revenue by selling on extended credit. Indeed it may be part of a firm's marketing strategy to capture market share by offering better credit terms than its competitors.
So, this ratio examines the average time in days taken to collect trade debts. It provides feedback on how well the level of debts is being managed. If debtors are taking too long to pay the firm may also experience difficulty in paying its debts. Apart from strictly cash businesses like supermarkets with virtually zero debtors, normal payment terms are at the end of the month following delivery, giving an average credit of between six and seven weeks.
Sales revenue is used, not cost of sales, since the goods or services have been sold and the price realised.
For this ratio we want the days to be as low a value as possible. Too high a figure may show the need for better credit control procedures.
Problems can arise over the debtor's figures. Some debtors will never pay, so should be written off. This will 'improve' the ratio but reduce the asset value of the firm. Writing off bad debts will then change a whole series of other ratios.
Follow the link below to see an example of a debt write-off.