Debt collection Period ratio: The ratio indicates the extent to which the debts have been collected in time. It gives the average debt collection period. The ratio is very helpful to the lenders because it explains to them whether their borrowers are collecting money within a reasonable time. An increase in the period will result in greater blockage of funds in debtors. The ratio may be calculated by any of the following methods.
Months (or days) in a year
(a) —————————————————-
Debtors’ turnover
Average Accounts Receivable x Months (or days) in a year
(b) ————————————————————————————–
Credit sales for the year
Accounts receivable
(c) ——————————————————————-
Average monthly or daily credit sales
In fact, the two ratios are interrelated Debtor’s turnover ratio can be obtained by dividing the months (or days)
In a YEAR by the average collection period (e.g., 12/2-6). Similarly Where the number of months (or days) in a year are divided by the debtors turnover, average debt collection period is obtained (i.e., 12/6 – 2 months)
Significance: Debtors’ collection period measures the quality of debtors since it measures the rapidity or slowness with which money is collected from them. A short collection period implied prompt payment by debtors. It reduces the chances of bad debts.
A longer collection period implies too liberal and inefficient credit collection performance. However, in order to measure a firm’s credit and collection efficiency its average collection period should be compared with the average of the industry. It should be neither too liberal nor too restrictive. A restrictive policy will result in lower sales which will reduce profits.
It is difficult to provide a standard collection period of debtors. It depends upon the nature of the industry, seasonable character of the business and credit policies of the firm. In general, the amount of receivables should not exceed a 3-4 months’ credit sales.
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