For small and medium businesses looking to expand and grow, managing cash flow can prove to be challenging. Despite this, some business owners in New Zealand and beyond overlook the importance of debtor days until they are faced with over-stretched working capital.
Whether it’s a late payment or an unexpected business expense, controlling your debtor days can help you overcome shocks to your cash flow.
A Guide to Debtor Days
Limiting the number of debtor days you offer is an integral part of maintaining reliable access to working capital. Essentially, it gives you greater control over how much time you need to wait to be paid money owed to you by your customers. That same working capital is essential for undisrupted and continued operations.
Before we go into the importance of controlling debtor days and even a guide in calculating them, first we should understand what debtor days are.
What are Debtor Days?
Most simply, debtor days measure the average time that it takes your business to get paid. In some instances, they are referred to as “day’s sales in accounts receivable”.
In other words, if the number of your debtor days is 21, then that means that on average it takes 21 days for you to receive payment from your customers or clients after raising and issuing an invoice.
According to Xero, a 30-day payment term was considered standard practice across New Zealand industries. However, studies have indicated that shorter payment terms, which are fast becoming the norm, are an effective way at reducing debtor days. This of course will depend on your industry, service and prior arrangements with customers.
Calculating Debtor Days
When calculating average debtor days, you will need the following data:
- Number of accounts receivable
- Number of days invoices have been outstanding
- Number of invoices
Then, you can take the number of accounts receivable, add up the number of days the invoices have been outstanding and then divide by the number of invoices.
The answer will give you a snapshot of your business in this particular moment of time. To better appreciate your cash flow situation–as opposed to the current data point only–you need to take an average of your debtor days over a more extended period of time. Most commonly, SMEs calculate debtor days on a monthly, quarterly or annual basis.
One of the standard, but not only, ways of doing so involves dividing trade receivables by revenue. The number can then be multiplied by the number of days in the time period you have chosen, i.e., a month, question or year.
The longer your chosen time frame, the more overall sense of your cash flow situation you will have.
Why knowing your debtor days is important
Knowing your debtor days allows you to measure the liquidity of your company. If you are able to track this number over time you can more easily identify where the average debtor days deviates from the norm and how to then respond through amended cash management.
If your average debtor days seem to be rising over time, this could be an indication that your payment collection process needs to be changed. Perhaps your customers are having their own cash management or credit issues. Perhaps your account receivables processes need improving. Either way, knowing your cash flow needs is the first step towards a solution.
If your debtor days are decreasing this could be a good sign as customers are settling payment more quickly or simply a reflection of seasonal factors that can be used to help alleviate ongoing cash management on your end.
Calculating Debtor Days
1. Accounts Receivable
You will first need to know your company’s average accounts receivable during the period you are wishing to examine.
You can calculate this by taking the numbers from the first and last day of the month (or other time period), adding those numbers together and dividing by two to get the average number.
2. Total Annual Sales
Next thing to calculate is the total annual sales. Once you have that number, then divide it by 365 to get the average sales per day.
With that number, you can then multiply the average sales per day by the number of days in the time period for which you are calculating, e.g., month or quarter.
3. Debtor Days Ratio
If you’re looking for your debtor days ratio, you will need to change Steps 1 and 2 slightly: First determine your average accounts receivable, divide that by the total annual sales and then multiply that last number by 365 days,
4. Debtor Days
With all of this data, you’re ready to use one of the two basic formulas for debtor days calculation. Remember: Adjust the numbers as necessary if you are working out the debtor days over a monthly or quarterly period accordingly.
- Debtor days = (average accounts receivable / average daily sales)
- Debtor days ratio = (average accounts receivable / total annual sales) x 365
Example for Calculating Debtor Days
Let’s take ABC Inc. as an example and assume they have annual sales of $750,000 and $100,000 in average account receivables.
Calculating the debtor days ratio is: (100,000/750,000) x 365 = 48.6
This calculation tells ABC Inc. that to maintain strong cash flow they need to collect debts from customers in at least 48.6 days (on average).
How to improve your Debtor Days
Extended terms for settling invoices can pose a problem for small and medium enterprises who are less able to sustain a shock or gap to their cash flow.
ScotPac NZ’s research through our SME Growth Index publications indicates an increase in SMEs looking to or undertaking a business restructuring to improve liquidity and boost cash flow.
During trying economic times, SMEs are even more vulnerable to short-term cash flow shortfalls than before, and certainly more susceptible than larger businesses. This is why monitoring cash flow and improving average debtor days is critical.
How can you improve the speed at which customers pay you?
- Effective Payment Collection Systems
This should include clear terms for payment, multiple payment options, a responsive customer service team and invoices being issued on time.
Additionally, you can consider providing a discount for customers who settle invoices early and before the payment terms. The increase in reliable cash flow is often worth the cost of a relatively small discount.
Invoice Finance – how to improve cash flow with ScotPac
The ScotPac team here in New Zealand can help you access invoice finance. This financial facility offers an effective funding solution to allow your business to leverage unpaid invoices and access payment faster to meet growth opportunities, smooth over cash flow gaps and ensure continued operations without disruption.
Our lending specialists can tailor a flexible financial solution to help you access an almost immediate cash advance of up to 95% of the value of your invoice/invoices.Knowing the importance of and calculations for your debtor days will help you realise your business’s cash flow situation and know what sort of solutions and improvements you need to take.