What is Days Sales Uncollected?
The Days’ Sales Uncollected also known as average collection period is one of the liquidity ratios that is measured to estimate the number of days before receivables will be collected. The ratio is used by creditors and investors widely to determine the short-term liquidity of the company. In terms of individual, the days’ sales uncollected ratio formula measures how long it will take for the customers to pay their credit card balances.
Components of Days Sales Uncollected
#1 – Accounts Receivable
Accounts Receivable is the proceeds or payments due to the company for its credit sales to its customers. When a company extends credit to the customer, it provides a time period to the customers for payment. The sales are realized when the invoice is generated.
#2 – Net Sales
Net sales are the company’s gross sales after returns, discounts, and allowances. Revenues reported on the income statement often represent net sales.
Days Sales Uncollected Formula
The days’ sales uncollected ratio divides accounts receivable by net sales and multiplies it by 365. It can be expressed as:
The result is expressed in days.
Inputs:
- Data of Accounts receivable can be picked up from the balance sheet.
- Credit sales have to be provided by the company. They are rarely reported in the separate head in the income statement.
Implication:
- Cash can be used for different operational activities if it is collected sooner. With lower days sales uncollected, liquidity and cash flows tend to increase. It also depicts that accounts receivables are not bad debts but are good in nature.
- A higher ratio shows the non-suitable collection process. Also, customers are not able or unwilling to pay. Such companies face problems to convert sales into cash.
Days Sales Uncollected Examples
Below are the Examples of days sales uncollected as follows.
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Example 1:
Suppose ABC Ltd. is a US based Company. At the end of March 2018,
- Accounts Receivable=$400,000.
- Net Credit Sales=$3,600,000.
So, the days’ sales uncollected will be
Days’ Sales Uncollected Formula = Accounts Receivable/Net Sales * 365
= 40.56~ 41 days.
So, ABC Co. will require approximately 41 days to collect the receivables.
Example 2:
Suppose Doro’s Pine Boards is a UK based retailer that offers credit to customers. Doro sells inventory to customers as per the credit policy wherein customers will pay within 30 days. Some customer pay promptly but some makes a delayed payment. Company’s financial statements have the following details:
- Accounts Receivable: £11,000
- Net Credit Sales: £131,000
Days’ Sales Uncollected Formula = Accounts Receivable/Net Sales * 365
=30.65 days~ 31 days
The company takes 31 days to collect cash. So, it is a good ratio that it is similar to the company’s set standard.
Advantages of Days Sales Uncollected
- If a department store or any organization sells its goods and services to its customers or clients on credit, they are ultimately selling more products. So, they have large accounts receivable on their books which is a good sign for their financial performance.
- For management, apart from liquidity, the ratio can be used to estimate the effectiveness of credit and collection activities.
- It can be used as a tool for peer creditors in the case one creditor finds a customer or party not creditworthy to give products on credit basis. It can work as a warning for others too.
- It can indicate if the company is maintaining customer satisfaction or if credit is being given to customers who are not creditworthy.
Disadvantages of Days Sales Uncollected
- A high ratio shows that the company is taking longer to collect money that may lead to cash flow problems.
- If a company’s payment of expenses is directly dependent on payments received from accounts receivable, a sharp rise in the ratio can disrupt this flow and drastic changes can be required.
- If a company has a volatile Days Sales Uncollected ratio, this may be cause for concern, but if a company’s ratio dips during a particular season each year, there is no issue.
Limitations of Days Sales Uncollected
If we consider the efficiency of a business, days sales uncollected comes with a set of limitations that are important for any investor to notice:
- When companies are compared on the basis of the ratio, it must be done in the same industry so that they can have similar business models and revenue. Companies of different size often have very different capital structures, which can influence calculations.
- The ratio is not useful in comparing companies with significant differences in the proportion of credit sales.
- The ratio is not a perfect indicator of a company’s accounts receivable efficiency, as it is dependent on volume and frequency of sales. Days Sales Uncollected must be used along with other metrics.
- It only accounts for credit sales. It ignores cash sales. If they were factored into the calculation, they would decrease the ratio.
Important Points
- Generally, Days Sales Uncollected ratio as below 45 days is considered low. However, it depends on business type and structure. There is no ideal ratio.
- The unusually high figure depicts casual credit policy or inadequate collection process. It could be possible because of the slow economy where customers are not able to pay.
- Another point to consider is Seasonality. The business sales may vary from month to month. So, the receivables figures in the numerator may not be a true picture of a particular time period or the entire year.
- Also, consider the distribution. Some of the receivables could be overdue since long and this may impact the measurement. Notation can be useful in this regard.
Conclusion
We can conclude that Days Sales Uncollected is widely used for collections and credit management. It assists with cash flow planning. It’s an indicator of the success of the collection’s department. However, it is largely affected by external factors like is the client’s business is powerful or what is the business condition as a whole. It is very important to keep a check on the ratio as it is an indicator of liquidity and solvency of the organization.
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