Trade receivables turnover (days)

Trade Receivables Turnover (Days)

Learning Objective

By the end of this lesson you will be able to:

• Calculate the trade receivables turnover ratio.
• Convert the ratio into Days Sales Outstanding (DSO).
• Interpret the result for credit‑control, cash‑flow and the concerns of owners, managers, creditors and other stakeholders.
• Use the ratio for year‑on‑year and inter‑firm comparisons and recognise its limitations.

Ratio Checklist – “Analysis and Interpretation” (Cambridge IGCSE Accounting 0452, 6.1‑6.4)

Key Definitions

• Trade receivables: Amounts owed to the business by customers for credit sales.
• Net credit sales: (Total sales – cash sales) – returns – allowances – discounts. Only the portion of sales made on credit is used; cash sales are excluded.
• Average trade receivables:
  $$\text{Average Receivables}= \frac{\text{Opening Receivables}+\text{Closing Receivables}}{2}$$ This arithmetic mean smooths seasonal peaks. If the period covered is not a full year, the average should still be calculated in the same way, but the denominator in the DSO formula must be adjusted (see below).
• Trade receivables turnover ratio: Number of times the average receivables are collected during the period.
• Days Sales Outstanding (DSO) / Trade receivables turnover (days): Average number of days required to collect cash from credit customers.

Quick‑Reference Table of Formulae

Why These Calculations Matter

• Credit control: A lower DSO means cash is collected quickly, reducing the risk of bad debts.
• Cash‑flow impact: High DSO ties up cash in receivables, limiting the ability to meet short‑term obligations or to fund growth.
• Working‑capital cycle: Together with inventory turnover and payables days, DSO shows how fast a business converts resources into cash.
• Stakeholder interest:
  • Owners / shareholders – assess liquidity and the profitability of credit policies.
  • Managers – monitor effectiveness of credit terms and collection procedures.
  • Bankers / creditors – evaluate the risk of lending; a very high DSO may signal cash‑flow weakness.
  • Suppliers – may adjust their own credit terms based on the buyer’s DSO.
  • Potential investors – use DSO as part of a broader efficiency analysis.

Step‑by‑Step Calculation Procedure

1. Identify the net credit sales for the period (see definition above).
2. Obtain the opening and closing balances of trade receivables from the balance sheet.
3. Calculate average trade receivables using formula (1).
4. Compute the turnover ratio with formula (2).
5. Convert the turnover ratio into days using formula (3).
   • If the data cover a full year, use 365; otherwise use the actual number of days in the period.
6. Interpret the result:
   • Compare with the company’s own credit policy.
   • Benchmark against industry averages or a rival firm.
   • Consider the impact on cash flow and borrowing capacity.

Worked Example – Full‑Year

ABC Ltd. – information for the year ended 31 December 2025:

1. Average receivables (1):
   $$\frac{30,000+42,000}{2}=36,000$$
2. Turnover ratio (2):
   $$\frac{240,000}{36,000}=6.67\ \text{times per year}$$
3. DSO (3, using 365 days):
   $$\frac{365}{6.67}\approx55\ \text{days}$$

Interpretation (single‑company)

• ABC Ltd. takes on average 55 days to collect cash from its credit customers.
• If the industry average is 45 days, ABC’s credit control is weaker; the business may need to tighten terms or improve collection.
• A very low DSO (e.g., 10 days) could indicate overly strict terms that might deter sales.
• From a cash‑flow viewpoint, cash is tied up for almost two months, which could limit the ability to meet short‑term liabilities or to obtain bank finance.

Worked Example – Half‑Year Period

XYZ Ltd. – information for the six‑month period ended 30 June 2025:

1. Average receivables = (20,000 + 28,000)/2 = 24,000
2. Turnover ratio = 120,000 / 24,000 = 5.0 times (for the six‑month period)
3. DSO = 180 / 5.0 = 36 days (because the period contains 180 days)

Inter‑Firm Comparison & Benchmarking

• When comparing DSO between two companies, ensure that:
  • Both use the same definition of net credit sales (i.e., cash sales excluded).
  • Both have similar credit policies or, if not, note the difference.
  • Seasonal effects are minimised – use full‑year figures or adjust for the same period.
• Example:
  Company A** DSO = 55 days (industry avg 45 days)
  **Company B** DSO = 42 days (same industry).
  Interpretation: Company B collects faster, suggesting stronger credit control, but it may also be using stricter credit terms that could limit sales volume.
• Use the comparison to make **recommendations** such as:
  • Reviewing credit limits for high‑risk customers.
  • Introducing early‑payment discounts.
  • Balancing collection efficiency with sales growth.

Limitations of the Trade Receivables Turnover Ratio

• Historical cost data: Receivables are recorded at the amount invoiced, not at their present value.
• Different accounting policies: Some firms may record sales on a cash basis, others on an accrual basis, affecting net credit sales.
• Seasonality: Even with an average balance, a business with strong seasonal peaks may have a misleading DSO if only a single year is examined.
• Non‑financial factors: Changes in market conditions, customer creditworthiness, or the introduction of new products can affect collection times without being reflected in the ratio.
• Quality of data: Errors in recording returns, allowances or discounts will distort net credit sales and therefore the ratio.

Common Pitfalls (and How to Avoid Them)

• Using total sales instead of net credit sales: Remember to exclude cash sales first, then deduct returns, allowances and discounts.
• Skipping the average receivables step: Using only the closing balance ignores fluctuations during the year and can give a misleading DSO.
• Applying the wrong time‑period factor: The divisor 365 assumes a full year. For half‑year, nine‑month, or any other period, replace 365 with the actual number of days.
• Failing to interpret the figure: A numeric result is only useful when linked to industry norms, cash‑flow implications and the concerns of different stakeholders.
• Over‑looking limitations: Always mention that the ratio is based on historical accounting records and may be affected by differing policies or seasonal effects.

Suggested Diagram