Hi guys,
I have two doubts pertaining to the concepts mentioned in the title of this thread.
How does the average days of recievables increase if we relax credit terms.
Can there be a scenario where the average days of recievables decrease and the weighted average collection period increase. If yes, please give a small example.
Average Days Receivables = 365/Receivables turnover ( assumed RT ratio on annual basis)
Receivables Turnover Ratio = Sales/Average Receivables
Since Average receivables balance is cut off balance on certain date (end of year if it’s calculated on annual basis), giving prolonged terms of payments to customers makes Average receivables balances in ratio above higher. Thus AVR Days receivables or Days of sales outstanding are longer.
Cheers!
When we relax credit terms won’t it increase credit sales in turn increasing recievables turnover which in turn decreases average days of receivables.
If it is question, the answer is no.
Since we have ratio derived from Income statement (Sales) and from BS (Account Receivables), both show the balances in a given (historical) period and since we had given relax credit terms to customers (extended invoice settlement days), this exactly means that we have higher balances of - not yet settled receivables according given level of sales.
You are right that intention of managament is likely to improve sales by relaxing credit terms to key customers but hereby with DSO ratio we just determine the current status of DSO.
Hope it’ s clear.
See it from this angle…
If we relax the credit terms to customer, the customer takes more time to pay back which increases the receivable turnover, which in turn reduces the Days of Sales Outstanding (DSO).
From your view, yes credit sales will likely improve due to the relaxed credit term, but so will average receivable, because the more you sell on credit, the more money you have out there to recover.
You got the idea all the way around. Look, if you relax the credit terms, your receivables will increase, so your average receivables will also increase. Thus, your receivables turnover ratio will decrease and your days of sales outstanding will increase. Flashback got the answer right, check his posts.
Otherwise, consider this doubt as you take photo snapshot at one cut in time and given that you just underline given status - DSO ratio, doesn’t matter what would happen or what would not happen in the future, for those assumptios there are other kind of analysis. This is accounting approach.
I think I’m getting it. Since we are only looking at the current status of DSO. So when we relax credit terms even the past invoices we have issued get their terms relaxed ?
Nope, only the new ones.
If the new existing terms of invoices don’t change how will the currecnt DSO change like how Flashback mentioned because the current receivables and the current sales won’t change (Only future sales and receivables will change). So how will the current DSO change.
Moreover in your post (quoted) you said that when we relax credit terms recievables increase. How does this happen if the relaxation of credit terms does not affect past invoices ?
Sorry for the repeated questions.
If the new existing terms of invoices don’t change how will the currecnt DSO change like how Flashback mentioned because the current receivables and the current sales won’t change (Only future sales and receivables will change). So how will the current DSO change.
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Assume Sales level did not change (we are talking about past (historical) data), so “all else equal” assumption, longer invoices settlement dates given to customers led to higher balance on Account receivable at the end of BS period, so Days of Sales Outstanding were extended. We are talking about action taken by management in the past not about action that will be taken in the future period.
Okay, I don’t know why suddenly. But makes sense now. Thanks a lot Flashback and Harrogath.
You are welcome.
When you look the line “Sales” in the income statement, it is composed of sales on cash and sales on credit. Those sales on credit will increase receivables. “Relax the credit terms” means that the company is offering credit to its customers in an easier way, thus the following sales made in the future will have a greater proportion of sales on credit. Of course the intention to relax credit terms is to increase total sales. Look this with numbers. Assume that beggining of period receivales were 100. If you hadn’t changed your credit terms, receivables would have been the same, however, you relaxed the terms, so receivables increased to 120. Now average receivables are 110 instead of 100. This change generates a decrease in receivables turnover ratio (annual sales/avg receivables), so DSO will increase (365/receiv turnover ratio). Follow the formulas and you will get this clear. Best regards!
In my area, only retailers sales on cash, all other sales on credit.