Have you ever looked at the email from your accountant, saying you had an excellent year, quarter, or month, and then looked at your bank account sitting far too close to zero for your comfort, and wondered why there’s such a discrepancy?
In this series of blog posts, we’ll explore some of the metrics that impact your cash flow, including those that cause that discrepancy.
One thing that can make quite a notable difference is your sales made on credit. That is, where you bill your customer and they pay you later, perhaps 30 or 60 or 90 days later.
The flip side of this, purchases made on credit, where you pay your supplier 30 or 60 or 90 days later, also makes quite a difference. We’ll look at that side of it in detail in the next post.
Accruals (not Cash) Accounting
These metrics only apply to you if you’re on accruals accounting, as opposed to cash accounting. All limited companies and some sole traders are on accruals accounting; sole traders with revenue up to £150k can choose cash accounting instead. You can always prepare your reports on a cash basis for your own internal management needs, if it suits.
I’ve written about the difference between cash and accruals accounting before. The super short version is that cash basis counts income and expenses when you receive/make the payment in your bank account; accruals basis generally counts it when the supply happens.
What are Debtors?
Your customers are either cash customers or credit customers, which has nothing to do with their method of payment, and everything to do with their speed of payment.
Cash customers pay you immediately.
At the supermarket for your weekly shop, you are a cash customer, whether you pay with your Mastercard or cold, hard cash.
Online, when you’ve bought something by paying then and there with a debit or credit card, you were a cash customer. You may have been automatically emailed an invoice, but you weren’t given time to pay it.
Credit customers pay you later. You’ve given them time to pay, which is what giving someone credit is.
To Mastercard, you are a credit customer: you have time to pay them for that weekly shop.
The customer who pays you 30 days later is a credit customer. They are indebted to you until they pay you, so they are your debtor.
To your supplier whom you pay 30 days later, you are a credit customer.
You are indebted to them until you pay, so you are their debtor.
They have given you credit, so they are your creditor.
Debtors are called Accounts Receivables in other countries – you can remember it being accounts you expect to receive money from – so you’ll also see the Debtor Turnover Ratio called the Receivables Turnover Ratio.
What is the Debtor Turnover Ratio and how do you find it?
The equation is:
Debtor Turnover Ratio = Net credit sales Average debtors
What are Net Credit Sales?
Net credit sales = Credit sales – Sales returns – Sales allowances
You should find all these figures at the top of your profit & loss report.
Credit sales, as mentioned above, are sales made only to the customers who you invoice and they pay you later.
Sales returns are how many of your sales were returned by customers for being faulty, or the wrong item delivered, etc.
Sales allowances are usually discounts given to customers due to a problem with the goods or services. Poor quality, incorrect prices on the original invoice, and short shipments show up here.
Sales returns and sales allowances show up as separate lines on your profit & loss report, so that you can easily spot it if they climb too high, and you know you need to revisit your quality control.
On many default charts of accounts (the list of categories you’ll see on your profit and loss and balance sheet reports), credit sales are not split from cash sales. To most easily use your Debtor Turnover Ratio, you’ll want to create a new account for credit sales so they stick out. It will also help you monitor the split more generally, so you can ensure you have a good diversification of income streams.
If your credit sales are not split out on your profit & loss report, get a Debtors Report to get your total credit sales.
What is your Average Debtor Balance?
Average debtor balance =
(Debtor balance at beginning of year – Debtor balance at end of year) 2
Your debtor balance is on your balance sheet. Look at the balance from the end of last year and the balance from the end of the year before. Average those two. That’s it, that’s all you need to do for this one!
Bonus: How do you find your Debtor Turnover in Days?
Debtor Turnover in Days = 365 Debtor Turnover Ratio
On average, your company collects its debts in this many days.
What is your Debtor Turnover Ratio?
Now go look at your own reports and find your Debtor Turnover Ratio. I’ll wait.
What does the Debtor Turnover Ratio tell us?
It tells us how many times per year your company collects its debts.
The higher this number, the faster your customers pay you.
How can you use your Debtor Turnover Ratio?
If you need better cash flow, you can keep an eye on this metric, working to increase it.
This is especially helpful during times of big growth or contraction.
If your debtor balance in £ doubles, it could be alarming, until you realise that your total credit sales in £ doubled at the same time.
The opposite is also true: if your debtor balance in £ halved, it could look like something to celebrate, until you realise that your total credit sales in £ also halved at the same time.
Using the Debtor Turnover Ratio will help you avoid undue alarm or undue complacency in these situations, helping you focus on what really matters.
You can use this ratio to help judge the impact of changes like reducing or extending credit terms (for example, offering customers 30 days instead of 60 days to pay), or increasing or decreasing credit limits.
What should you know when comparing Debtor Turnover Ratios?
Beware of unintended consequences!
If you make this a metric that your finance team is evaluated on, for example, they might aim to improve it by stopping or reducing credit offered to customers. That could be the right choice, but it could instead lead to fewer sales, when prospects and customers find new suppliers.
It’s always best to use KPIs in conjunction with each other, rather than focusing too much on one at a time.
If you’re using the Debtor Turnover Ratio to help with your cash flow, definitely look at your key cash flow figures alongside this ratio each month: Cash in, Cash out, Cash on hand at the end of the month.
Conclusion
In this post, we’ve learned about
- Your debtor turnover ratio
- Your debtor turnover in days
- Credit vs cash sales
- Cash vs accruals accounting
- Sales returns, Sales allowances, and Net credit sales
- A top tip for setting up your chart of accounts
- Your average debtor balance
We’ve seen that:
- You can improve your cash flow by increasing your debtor turnover ratio.
- You can use this metric to gauge the impact of credit policy changes.
- This metric is especially helpful in times of big growth or contraction, when £ figures could unduly alarm (or the opposite).
Next time, we’ll consider the other side of the coin, your Creditor Turnover Ratio – how quickly you pay your suppliers.
Hi, I’m Sara-Jayne Slocombe of Amethyst Raccoon. I help your small business thrive using the power of your numbers, empowering you so that you have the confidence and knowledge to run your business profitably and achieve the goals you’re after.
I am a UK-based Business Insights Consultant, which means I look at your data and turn it into information and insights. I separate the noise from the signal and translate it all into actions that you can actually take in your business.
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