IBBusinessDPBusiness ManagementHLRevision Notes3. Finance & Accounts3.6 Efficiency Ratio AnalysisEfficiency Ratios: Debtor & Creditor Days

Efficiency Ratios: Debtor & Creditor Days (DP IB Business Management)

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Debtor Days

  • Debtor days measures the average number of days it takes for a business to collect money from its debtors

  • Businesses often provide a period of trade credit to customers

    • In the UK 30 to 60 days is typical

    • The growth of promotional 'buy now, pay later' deals has increased the level of debtors for some businesses

  • It is calculated using the formula

Debtor space days space equals space fraction numerator Debtors over denominator Total space credit space sales space revenue end fraction space cross times space 365
 

  • Businesses aim for a low or reducing ratio

    • This indicates efficiency in collecting outstanding debts from credit customers

    • Collecting debts promptly can improve cash flow

Worked Example

YakPur Fashions is a manufacturer and exporter of high quality fashion outerwear

A selection of YakPur Fashions' financial performance indicators are shown in the table

Selected Financial Performance Data 2022

YakPur Fashions

 

€

Stock held on 1st January 2022

47,600

Credit Sales Revenue

241,200

Cost of Sales

112,400

Stock held on 31st December 2022

26,000

Debtors on 31st December 2022

31,200

Creditors on 31st December 2022

28,500

(a) Calculate YakPur Fashion's Debtor Days ratio for 2022

(2 marks)

Step 1: Divide debtors by credit sales revenue

fraction numerator € 31 comma 200 over denominator € 241 comma 200 end fraction equals space 0.1294      (1)

 

Step 2: Multiply the outcome by 365

0.1294 space cross times space 365 equals space 47.23 space days      (1)

  • It takes YakPur Fashions an average of 47.23 days to collect money owing from debtors

Ways to Reduce the Debtor Days Ratio

  • Maintaining open communication with customers helps to address any issues promptly

Ways to Reduce the Debtor Days Ratio

Method

Explanation

Streamline invoicing and credit control processes

  • Send out invoices promptly 

  • Clearly outline payment terms and due dates on invoices

  • Send reminders before and after the due date to prompt timely payments

  • Have a systematic approach for handling overdue accounts including follow-up procedures

Establish and monitor creditworthiness of customers

  • Conduct credit checks on customers - especially before extending trade credit

  • Set appropriate credit limits based on the customer's financial health

  • Keep a close eye on customer payment patterns

  • Periodically review and adjust trade credit terms

  • Implement an effective system for tracking and managing debtors

Improve payment systems

  • Make it easy for customers to pay by offering various payment methods

  • Use accounting software or automation tools to streamline invoicing and payment processes

Provide incentives for early payment

  • Encourage customers to pay before an invoice's due date by providing discounts or other incentives such as free delivery

  • If these methods fail to persuade customers to pay their invoices on time a business has a range of further options. These methods should be pursued with caution as relationships with customers may be damaged

Further Ways to Reduce the Debtor Days Ratio

Method

Explanation

Refuse to provide further goods unless outstanding debts are paid

  • Suspend the despatch of an order until an outstanding payment is received

  • Refuse to accept further orders

Threaten to take legal action

  • In the UK small businesses can make use of the Small Claims Court to recover modest debts from customers

Creditor Days

  • Creditor days measures the average number of days a business takes to pay its creditors

  • It is calculated using the formula

Creditor space days space equals space fraction numerator Creditors over denominator Cost space of space sales end fraction space cross times space 365
 

  • Businesses generally aim for a high or increasing ratio

    • This indicates skills of negotiation in arranging extended credit terms with suppliers

    • Delaying payments to suppliers can improve cash flow

  • However, taking longer than agreed to pay outstanding invoices may have negative consequences

    • Relationships with important suppliers may worsen

      • They are less likely to extend further trade credit 

      • Penalties may be issued for late payment 

      • Orders may be delayed until payment is received

    • Creditworthiness may worsen

      • A business may fail credit checks

      • Unable to place orders with other suppliers

      • Less chance of obtaining trade credit elsewhere

      • Could impact applications for borrowing e.g. loans

Worked Example

YakPur Fashions is a manufacturer and exporter of high quality fashion outerwear

A selection of YakPur Fashions' financial performance indicators are shown in the table

Selected Financial Performance Data 2022

YakPur Fashions

 

€

Stock held on 1st January 2022

47,600

Credit Sales Revenue

241,200

Cost of Sales

112,400

Stock held on 31st December 2022

26,000

Debtors on 31st December 2022

31,200

Creditors on 31st December 2022

28,500

(a) Calculate YakPur Fashion's Creditor Days ratio for 2022

(2 marks)

Step 1: Divide creditors by cost of sales

fraction numerator € 28 comma 500 over denominator € 112 comma 400 end fraction equals space 0.2536      (1)

 

Step 2: Multiply the outcome by 365

0.2536 space cross times space 365 equals space 92.56 space days      (1)

Yakpur takes an average of 92.56 days to settle supplier invoices

Ways to Improve the Creditor Days Ratio

  • Larger businesses often employ a credit controller to manage negotiations about payments with their suppliers. This person has a range of methods which they can use to improve the creditor days ratio

Improving the Creditor Days Ratio

Method

Explanation

Develop close relationships with suppliers

  • Communicate regularly with named individuals and provide feedback

  • Avoid confrontation if conflicts arise

Improve the businesses credit rating

  • Make payments in full within the trade credit period

  • Make prompt payments on other forms of credit such as loans or credit cards

Seek suppliers that offer extended trade credit terms

  • Approach suppliers and negotiate for extended payment terms

  • Highlight strong payment history and the value of ongoing business in negotiations

Examiner Tips and Tricks

Improving debtor and creditor days should have a positive impact on business liquidity - and improve the working capital situation too

As a result making efforts to take the steps outlined above can improve the stability of a business and increase its chances of survival

Insolvency Versus Bankruptcy

  • Insolvency refers to the inability of a business to pay debts and continue trading

  • Bankruptcy occurs when a business ceases to trade and the value of its possessions are distributed to its creditors

  • The outcome of insolvency depends on the ownership type of the business

Diagram: comparing bankruptcy and liquidation

Insolvency can lead to bankruptcy for unincorporated businesses and to administration or liquidation for companies
Insolvency can lead to bankruptcy for unincorporated businesses and to administration or liquidation for companies

  • Insolvency for a sole trader or partnership can lead to a legal declaration of bankruptcy by a court of law

    • The assets of the business and its owners may be sold to settle outstanding debts

  • Companies may liquidate or enter into administration

    • Liquidation involves the selling of business assets to settle outstanding debts and dissolve a company

    • Administration protects businesses from administration whilst it attempts to settle debts and continue trading

      • If administration fails a company faces liquidation

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