The ratio indicates how many times a company collects its average trade receivables during a period. A higher ratio means quicker collection of receivables.
Given the answer choices, the correct ratio is: (2) 8.18 times
The Average Collection Period is calculated using the following formula:
Average Collection Period = $ \frac{365}{\text{Trade Receivables Turnover Ratio}} $
In this case, with a Trade Receivables Turnover Ratio of 8.18 times, the Average Collection Period is:
Average Collection Period = $ \frac{365}{8.18} = 44.6 \approx 45 \, \text{days} $
Thus, the correct answer is: (3) 45 days
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Average Collection Period
The Average Collection Period can be derived from the Trade Receivables Turnover Ratio. It indicates the average number of days it takes for a company to collect its receivables.
Calculation
Using the Trade Receivables Turnover Ratio from Question 27 (assumed to be 8.18):
Rounded to the nearest whole number, the Average Collection Period is approximately 45 days.
Interpretation
An Average Collection Period of approximately 45 days indicates that, on average, it takes the company 45 days to collect its receivables. This can be compared to industry benchmarks and the company's credit terms to assess the effectiveness of its collection efforts. A shorter period is generally preferred.
Assuming there is no additional information about opening balances for Creditors and Bills Payable, we will use the ending balances as the average. Hence,
Average Trade Payables = Total Trade Payables = ₹1,42,000
Substitute these values into the formula:
Trade Payables Turnover Ratio = ₹4,20,000 / ₹1,42,000 ≈ 2.96 times
Therefore, the Trade Payables Turnover Ratio is 2.96 times.
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Trade Payables Turnover Ratio
The Trade Payables Turnover Ratio is calculated by dividing Purchases by the total trade payables (Creditors + Bills Payable). This ratio indicates how many times a company pays off its payables during a period.
Calculation
Given values:
Purchases: ₹ 4,20,000
Creditors: ₹ 90,000
Bills Payable: ₹ 52,000
The formula for the Trade Payables Turnover Ratio is:
This ratio of 2.96 indicates that the company pays off its payables approximately 2.96 times during the period. A higher ratio may indicate that the company is not taking full advantage of available credit terms from its suppliers, while a very low ratio might suggest difficulty in paying suppliers on time.
Trade Receivables Turnover Ratio and Trade Payables Turnover Ratio are categorized as Activity Ratios.
Activity Ratios, also known as efficiency or turnover ratios, measure how effectively a company utilizes its assets. These ratios assess the performance related to the management of current assets and liabilities, translating into operational efficiency. Let's consider the given data for further analysis:
Particulars
₹
Revenue from Operations
8,75,000
Creditors
90,000
Bills Receivable
48,000
Bills Payable
52,000
Purchases
4,20,000
Trade Debtors
59,000
To calculate:
Trade Receivables Turnover Ratio: It evaluates how quickly a firm converts its receivables into cash. The formula is \( \text{Trade Receivables Turnover Ratio} = \frac{\text{Net Credit Sales}}{\text{Average Trade Receivables}} \). Here, we'll use Revenue from Operations (assuming all sales were credit sales) and Trade Debtors for average trade receivables.
Trade Payables Turnover Ratio: It assesses how quickly a company pays off its suppliers. The formula is \( \text{Trade Payables Turnover Ratio} = \frac{\text{Net Credit Purchases}}{\text{Average Trade Payables}} \). Here, Purchases will represent Net Credit Purchases, and Creditors or Bills Payable indicate trade payables.
These ratios are crucial indicators of the company's operational efficacy in managing its working capital related to receivables and payables. Understanding and optimizing these can result in better cash flow management and operational success.
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Activity Ratios
The ratios we have discussed (Trade Receivables Turnover Ratio, Average Collection Period, Trade Payables Turnover Ratio, and Average Payment Period) measure the efficiency of a company's asset usage. Therefore, these ratios are classified as Activity Ratios.
Purpose of Activity Ratios
Assess how effectively a company utilizes its assets to generate revenue.
Indicate the speed at which various accounts (e.g., receivables, payables, inventory) are converted into sales or cash.
Help identify potential operational inefficiencies.
Examples of Activity Ratios Discussed
Trade Receivables Turnover Ratio: Measures how efficiently a company collects its receivables.
Average Collection Period: Indicates the average number of days it takes to collect receivables.
Trade Payables Turnover Ratio: Measures how efficiently a company pays its suppliers.
Average Payment Period: Indicates the average number of days it takes to pay suppliers.
