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

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Last updated

29 October 2024

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

$Debtor days = \frac{Debtors}{Total credit sales revenue} \times 365$

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

$\frac{€ 31, 200}{€ 241, 200} = 0.1294$ (1)

Step 2: Multiply the outcome by 365

$0.1294 \times 365 = 47.23 days$ (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

$Creditor days = \frac{Creditors}{Cost of sales} \times 365$

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

$\frac{€ 28, 500}{€ 112, 400} = 0.2536$ (1)

Step 2: Multiply the outcome by 365

$0.2536 \times 365 = 92.56 days$ (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 Tip

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 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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