The Debt Turnover Ratio
The debt turnover ratio, also called the debtors turnover ratio or the accounts receivable ratio, indicates how effective a company is at selling on credit and collecting debt. As with all ratios, the debt turnover ratio is only useful when viewed over time to determine whether it is improving or degrading. It can be an early indicator of an impending cash crisis and is an important tool in a manager's financial analysis toolbox.
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Calculating the Debt Turnover Ratio
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The debt turnover ratio is calculated by dividing total sales for the period by the average accounts receivable balance. The average is found by adding the accounts receivable balance at the beginning and end of the year and dividing by 2. For example, if a company's sales are $125,000 in the year and it started with a receivables balance of $8,000 and ended with $11,500, the average receivables for the year would be $9,750. The debt turnover ratio would be 12.8 times. This means that the company turned over its receivables 12.8 times in the year. The higher the ratio is, the faster a company collects its accounts receivable.
What Does the Ratio Indicate?
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The debt turnover ratio indicates the velocity at which a company collects its receivables. A single ratio calculation doesn't say anything about the company because every company has its own collection period. It is the direction of the ratio over time that tells a manager whether the company is collecting its receivables faster or slower than before. If the ratio gets progressively lower, it can indicate that the company isn't converting sales into cash as quickly, which can put a strain on the company's cash flows. It can be a leading indicator of a collection process problem or a customer quality problem.
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Reasons for a Low Debt Turnover Ratio
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A declining debt turnover ratio can indicate that the company will soon experience tighter cash flow. The ratio itself does not suggest what is causing the problem. A manager must delve into the collection process to see what is causing collections to slow. One common reason for a lower debt turnover ratio is a change in the way the company collects receivables. Often, if a new accounts receivable clerk has not been trained properly, he may not follow up on late bills by calling the accounts or sending overdue statements. This means that the average collection period increases and the ratio decreases. Another common reason is a change in the quality of new customers. This happens frequently when a business grows quickly. If there is a flood of new customers who are extended credit without proper investigation, it may take longer for the company to collect its receivables.
How to Improve the Debt Turnover Ratio
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If a company wants to improve its accounts receivable collections and its debt turnover ratio, it must review its collection procedures. Credit policies must be made clear on all invoices and appropriate interest and penalties set for late payment. Follow up for overdue accounts must be consistent and timely as many customers will take as much advantage of lax collection policies as they can. Credit should only be extended to customers after their business and financial past has been reviewed to ensure that they have a solid history of paying vendors on time.
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References
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