If you’re a business owner, nobody has to tell you about the importance of cash flow. But many business owners overlook debtor days until working capital becomes stretched due to a late payment or unexpected cost.
Limiting the number of debtor days is vital for maintaining a healthy cash flow. It shows you how long you need to wait for the money owed that your business is counting on for its operations.
In this guide, we’ll outline what debtor days are and why they’re important. We’ll also reveal how to calculate debtor days and the steps you can take to get your customers to pay on time.
What Are Debtor Days?
In simple terms, debtor days measure the average time it takes a business to get paid. Debtor days are sometimes called “day’s sales in accounts receivable.”
Debtor days are the number of days between when an invoice is issued and when the payment is collected. So if your average invoice is paid in 21 days, your average number of debtor days is 21.
According to Business Australia, the average payment term is 37 days. But this can vary depending on your industry.
To calculate your average debtor days, you take the number of accounts receivable, add up the number of days the invoices have been outstanding, and divide by the number of invoices.
Of course, doing this for one day only gives you a snapshot of your business at one moment in time. To truly understand your cash flow situation, you need to take an average over a more extended period. For this reason, debtor days are typically calculated on a monthly, quarterly, or annual basis.
This can be done in a number of ways, but the standard method involves dividing trade receivables by revenue. That number is then multiplied by the number of days in the month, quarter, or year. By looking at a longer time frame, you get a better overall sense of how your business is doing.
Why Are Debtor Days Important?
Debtor days are a measure of your company’s liquidity. If you track this number over time, you can identify times where the number varies from the norm. This indicates there are either positive or negative trends in your cash flow situation.
For example, suppose your average debtor days are rising. In that case, you may need to make some changes to your company’s payment collection processes. It’s also possible that your clients are having credit issues. Either way, it’s important to identify the potential problem so you can take steps to improve your cash flow.
A decreasing number of debtor days is generally good news, at least in the short term. But, at the same time, it’s important not to read too much into people making their payments more quickly.
Look at the historical context, and see if seasonal factors influence customer payment times. For example, if you primarily deal with companies in the same industry, it could be the case that your customers are flush with cash every year at this time.
How to Calculate Debtor Days?
The debtor days formula is pretty straightforward:
First, you need to know your company’s average accounts receivable at the beginning and the end of the period you want to examine.
If you wanted to calculate your average monthly accounts receivable, you’d take the numbers from the first and the last of the month. Then, add those numbers together, divide them by two, and you get your average accounts receivable.
Next, look up the company’s total annual sales, and divide it by 365. If you’re calculating the sales for a month or a quarter, use the appropriate numbers for that period. This gives you the average daily sales.
You need to do things differently if you’re calculating your debtor days ratio. You first determine the average accounts receivable, divide that by the total annual sales, and multiply by 365 days.
The two basic formulas for debtor days calculation are as follows. Adjust the numbers as necessary for monthly or quarterly calculations:
Debtor days = (average accounts receivable / average daily sales)
Debtor days ratio = (average accounts receivable / total annual sales) x 365
Debtor Days Calculation Example
ABC Corporation has annual sales of $750,000 and $100,000 in average account receivables.
The debtor days ratio calculation for that period:
(100,000/750,000) x 365 = 48.6
So to maintain healthy cash flow, ABC Corporation needs to collect its debts in at least 48.6 days on average.
What Do Debtor Days Mean for My Business?
The debtor days ratio lets you know how long it’s taking for you to collect your debts. The longer the debtor day period, the longer it takes for your customers to pay you.
Accounts receivable fall on the positive side of the balance sheet. But as long as they remain unpaid, these debts represent cash that your company doesn’t have on hand. If you want to invest in your growth, you’ll need to rely on credit.
When evaluating your debtor days, it’s important to compare it to your payment terms. For example, if your terms require payment within 30 days and your debtor days are 50 days, your debtors clearly aren’t making their payments on time. In that scenario, it’s worth reconsidering your collections process.
Debtor days are driven by several factors, not all of which are under your control. For example, you may have a large enterprise client that makes all of its payments on its own standard terms, regardless of vendor. There can also be industry norms that dictate when certain debtors make payments.
It’s important to understand your company’s debtor days. By having a firm grip on your company’s financial situation, you’ll be able to predict your cash flow needs and avoid working capital becoming an issue due to late or extended payments.
Why Extended Payment Terms Are a Problem for SMEs
Debtor days are particularly concerning for small and medium enterprises (SMEs). That’s because SMEs are particularly vulnerable to the recent increase in late payments.
According to our latest SME Growth Index research, around four out of 10 SMEs undertook a restructuring of their business in the past 12 months. Of those businesses, nearly 23% restructured to improve liquidity and boost cash flow.
The global pandemic has revealed that SMEs are less able to weather short-term cash flow shortfalls than larger businesses. As a result, it’s more important than ever for small businesses to monitor their cash flow.
How to Improve Average Debtor Days
So, how do you make sure you’re getting paid as quickly as possible? It starts with building an effective payment collection system. This can include:
- Creating clear terms of payment
- Issuing invoices on time
- Providing several payment options
- Responsive customer service
You can also give a discount to customers who pay their invoices early. The increase in cash flow can be well worth the cost of a small discount.
For more advice on speeding up customer payment and reducing debtor days, read our guide on How To Collect Unpaid Invoices From Customers.
Using Invoice Finance to Improve Cash Flow
Invoice Finance is one of the best solutions if your business is being held back by extended payment terms and slow-paying customers. It’s a funding solution that helps you reinvest in your business faster than if you had to wait for your customers to pay their invoices in full.
Instead of waiting 30+ days for customer payment, you can submit the invoice for financing and receive an immediate cash advance of up to 95% of the invoice value.
Depending on the agreement terms, the Invoice Finance company can also handle the collections process. As a result, you can focus on growing your business, not chasing customer payments and worrying about cash flow.
To see how Invoice Finance can make a real impact on business growth, read our case study on how Tasmanian spirits producer Strait Brands used the extra liquidity to drive national and overseas expansion.
Improve Your Business Cash Flow with ScotPac
Now you know the importance of debtor days and how to calculate the metric at your business. Knowing how your collections process is performing and the average time it takes you to get paid can help you prepare for periods when cash flow becomes stretched.
If extended payment terms are stunting the growth of your business, speak to our expert business finance team here at ScotPac. We provide a range of funding solutions designed to unlock value and speed up business growth. Use our simple online enquiry form or give us a call on the number below.