trade receivables turnover (days): calculation and interpretation

10.2 Analysis of Published Accounts – Financial‑Efficiency Ratios

Objective

To enable candidates to calculate, interpret and evaluate the three financial‑efficiency ratios required by the Cambridge 9609 syllabus, and to use the results in exam answers and business‑decision making.

Why Financial‑Efficiency Ratios Matter

• They measure how quickly a business turns its working‑capital components (receivables, payables, stock) into cash.
• They reveal the effectiveness of credit, collection and inventory policies.
• They help identify cash‑flow problems before they become critical.
• They provide a basis for benchmarking against industry norms and competitors.
• They feed directly into the cash‑conversion cycle, influencing short‑term financing needs.

Definitions & Purpose (Syllabus wording)

Ratio	Definition (as a financial‑efficiency ratio)	Purpose
Trade Receivables Turnover (ratio & days)	Measures how many times per year a business collects its credit sales and the average number of days required to collect them.	Assess credit control and the speed of cash inflow from customers.
Trade Payables Turnover (ratio & days)	Measures how many times per year a business pays its credit purchases and the average number of days it takes to settle them.	Evaluate the efficiency of payment policy and the use of supplier credit.
Inventory Turnover (ratio & days)	Measures how many times per year stock is sold and replaced and the average number of days stock is held.	Analyse stock‑holding efficiency and the impact on cash tied up in inventory.

Key Formulae (annual basis)

Ratio	Turnover (times)	Average period (days)
Trade Receivables Turnover	\(\displaystyle \text{Turnover}= \frac{\text{Net Credit Sales}}{\text{Average Trade Receivables}}\)	\(\displaystyle \text{Days}= \frac{365}{\text{Turnover}} = \frac{\text{Average Trade Receivables}\times365}{\text{Net Credit Sales}}\)
Trade Payables Turnover	\(\displaystyle \text{Turnover}= \frac{\text{Net Credit Purchases}}{\text{Average Trade Payables}}\)	\(\displaystyle \text{Days}= \frac{365}{\text{Turnover}} = \frac{\text{Average Trade Payables}\times365}{\text{Net Credit Purchases}}\)
Inventory Turnover	\(\displaystyle \text{Turnover}= \frac{\text{Cost of Goods Sold (COGS)}}{\text{Average Inventory}}\)	\(\displaystyle \text{Days}= \frac{365}{\text{Turnover}} = \frac{\text{Average Inventory}\times365}{\text{COGS}}\)

Alternative figures (syllabus reminder)

• When the published accounts do not separate credit from cash sales, Net Credit Sales can be approximated by Total Sales – Cash Sales. If cash‑sales data are unavailable, many exam questions allow the use of Total Sales as an acceptable proxy, provided the candidate states the assumption.
• Similarly, Net Credit Purchases may be approximated by Total Purchases – Cash Purchases or, when only COGS is given, by using COGS (assuming all purchases are on credit).

Average Balances

Using an average smooths out fluctuations during the period:

\[ \text{Average Balance}= \frac{\text{Opening Balance}+\text{Closing Balance}}{2} \]

For highly seasonal businesses, use quarterly or monthly averages instead of the simple yearly average.

1. Trade Receivables Turnover (ratio & days)

Definition & purpose

Measures the speed at which credit sales are collected and indicates the effectiveness of the firm’s credit‑control policy.

Step‑by‑step calculation

1. Identify **Net Credit Sales** for the period (total sales – cash sales).
2. Calculate **Average Trade Receivables** = (Opening + Closing) ÷ 2.
3. Compute the turnover ratio using the formula above.
4. Convert the ratio to days (average collection period) using the “Days” formula.

Worked example

Item	Amount (£)
Net credit sales (year)	480 000
Opening trade receivables	45 000
Closing trade receivables	55 000

Calculations

• Average receivables = \((45 000+55 000)/2 = 50 000\)
• Turnover = \(480 000 ÷ 50 000 = 9.6\) times per year
• Days = \(365 ÷ 9.6 ≈ 38\) days

Interpretation: The business collects its credit sales in about 38 days. If the industry average is 45 days, the firm’s credit control is more efficient than most competitors.

Link to the cash‑conversion cycle

The collection period (receivables days) is one of the three components of the cash‑conversion cycle:

\[ \text{Cash‑conversion cycle}= \text{Inventory days} + \text{Receivables days} - \text{Payables days} \]

A shorter receivables period reduces the overall cycle, lowering the need for short‑term financing.

Improvement actions

• Introduce early‑payment discounts (e.g., 2 % if paid within 10 days).
• Strengthen credit checks and set tighter credit limits for high‑risk customers.
• Adopt electronic invoicing and automated reminders.
• Review and renegotiate credit terms with major customers.

Limitations

• Only reflects the average collection period; it hides variations among different customer groups.
• Depends on the accuracy of the “net credit sales” figure – if cash sales are mis‑recorded, the ratio is distorted.
• Seasonal spikes can inflate or deflate the average if a simple yearly average is used.

2. Trade Payables Turnover (ratio & days)

Definition & purpose

Shows how quickly a business settles its credit purchases and indicates the utilisation of supplier credit.

Step‑by‑step calculation

1. Identify **Net Credit Purchases** for the period (total purchases – cash purchases). If only COGS is given, use COGS as an approximation.
2. Calculate **Average Trade Payables** = (Opening + Closing) ÷ 2.
3. Compute the turnover ratio.
4. Convert to days (average payment period).

Worked example

Item	Amount (£)
Net credit purchases (year)	300 000
Opening trade payables	40 000
Closing trade payables	50 000

Calculations

• Average payables = \((40 000+50 000)/2 = 45 000\)
• Turnover = \(300 000 ÷ 45 000 = 6.7\) times per year
• Days = \(365 ÷ 6.7 ≈ 55\) days

Interpretation: The firm takes about 55 days on average to pay its suppliers. If the industry norm is 45 days, the business is extending credit, which improves cash flow but may strain supplier relationships or cause loss of cash‑discounts.

Link to the cash‑conversion cycle

Payables days reduce the cash‑conversion cycle; a higher number of days means the firm can hold cash longer before paying suppliers.

Improvement actions

• Negotiate longer credit terms with key suppliers.
• Take advantage of cash‑discounts when the firm has surplus cash.
• Consolidate purchases to obtain better terms.
• Maintain good supplier relationships to avoid jeopardising supply.

Limitations

• Turnover may be understated if purchases are recorded on a cash basis while payables are on credit.
• Does not differentiate between early‑payment discounts taken and full‑price payments.
• High payables days can be a sign of cash‑flow distress rather than strategic credit use.

3. Inventory Turnover (ratio & days)

Definition & purpose

Indicates how many times stock is sold and replaced during a period and the average length of time inventory is held.

Step‑by‑step calculation

1. Identify **Cost of Goods Sold (COGS)** for the period.
2. Calculate **Average Inventory** = (Opening + Closing) ÷ 2.
3. Compute the turnover ratio.
4. Convert to days (average holding period).

Worked example

Item	Amount (£)
COGS (year)	360 000
Opening inventory	30 000
Closing inventory	42 000

Calculations

• Average inventory = \((30 000+42 000)/2 = 36 000\)
• Turnover = \(360 000 ÷ 36 000 = 10\) times per year
• Days = \(365 ÷ 10 = 36.5\) days (≈ 37 days)

Interpretation: The firm holds inventory for about 37 days before it is sold. If the industry average is 45 days, the business is managing stock efficiently, reducing holding costs and the cash‑conversion cycle.

Link to the cash‑conversion cycle

Inventory days are the first component of the cash‑conversion cycle; lower inventory days shorten the cycle and free up cash for other uses.

Improvement actions

• Adopt Just‑In‑Time (JIT) ordering or more accurate demand forecasting.
• Implement ABC analysis to focus control on high‑value items.
• Review and eliminate slow‑moving or obsolete stock.
• Introduce regular stock‑taking and tighter reorder points.

Limitations

• COGS may include purchases that are not yet reflected in inventory, distorting the ratio.
• Average inventory masks large fluctuations; seasonal businesses should use quarterly averages.
• Does not reflect the quality or obsolescence risk of the inventory held.

Methods of Improving Overall Financial Efficiency

• Credit control: tighten credit limits, perform credit checks, offer early‑payment discounts (e.g., 2 % discount if paid within 10 days).
• Collection procedures: issue invoices promptly, use electronic invoicing, send regular reminders, and consider factoring for high‑risk receivables.
• Supplier negotiations: seek longer credit periods, negotiate cash‑discounts for early payment, consolidate purchases to achieve economies of scale.
• Inventory management: implement JIT, improve forecasting, use ABC analysis, and conduct regular stock reviews.
• Cash‑flow planning: prepare short‑term cash‑flow forecasts, use overdrafts or short‑term loans to cover temporary gaps, and monitor the cash‑conversion cycle.

Limitations of Financial‑Efficiency Ratios (overall)

• Ratios are based on accounting data, which may be affected by estimation errors, different accounting policies, or one‑off items.
• They provide a snapshot of average performance and conceal intra‑period variations.
• Comparisons are only meaningful when the same accounting conventions (e.g., credit vs. cash basis) are used.
• External factors such as seasonal demand, economic cycles, or changes in industry credit terms can distort the ratios.
• Ratios do not measure profitability; a firm may have excellent efficiency but still be unprofitable.

Common Pitfalls (exam focus)

• Using total sales/purchases instead of net credit figures without stating the assumption.
• Forgetting to average opening and closing balances (or using the wrong period for averages).
• Applying the “days” formula incorrectly – remember Days = 365 ÷ Turnover.
• Ignoring discounts, returns or bad‑debt allowances that affect net credit sales/purchases.
• Overlooking seasonality – use quarterly/monthly averages for businesses with strong seasonal swings.

Exam Checklist

1. State the exact formulae for the ratio and for the average period (days).
2. Show all intermediate calculations:
   • Net credit sales or purchases (state any assumptions).
   • Average balance.
   • Turnover ratio.
   • Days.
3. Provide a concise interpretation that:
   • Links the result to cash flow and the cash‑conversion cycle.
   • Compares with the previous year, industry average or the firm’s credit terms.
4. Comment on possible actions the business could take to improve the figure (e.g., tighter credit control, early‑payment discounts, longer supplier terms, JIT inventory).
5. Where relevant, note any limitations of the ratio for the particular business.