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

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

• 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

Ways to reduce the debtor days ratio

• 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

• Refuse to provide further goods unless outstanding debts are paid

  • Suspend the despatch of new orders until payment for previous goods is received

  • Refuse to accept additional orders from the customer until debts are cleared

  • This approach applies pressure to the customer to settle their account in order to continue the business relationship

• Threaten to take legal action

  • Warn the customer that legal steps may be taken if the debt remains unpaid

  • In the UK, small businesses can use the Small Claims Court to recover modest debts

  • Legal action can serve as a deterrent and demonstrate that the business is serious about recovering what it is owed

Creditor days

• Creditor days measures the average number of days a business takes to pay its creditors
  

• It is calculated using the formula

• 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

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

  • Develop close relationships with suppliers

    • Communicate regularly with specific contacts at the supplier

    • Provide useful feedback to build trust

    • If conflicts arise, aim to resolve them calmly rather than through confrontation

    Improve the business's credit rating

    • Pay invoices in full and within the agreed trade credit period

    • Make prompt payments on other credit agreements, such as loans or business credit cards, to build a strong credit history

    Seek suppliers that offer extended trade credit terms

    • Reach out to suppliers and try to negotiate longer payment periods

    • Use your good payment history and long-term value as a customer to support your request

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

Comparing bankruptcy and liquidation

• 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