Watch Debtor Days Of Your Portfolio Companies To Monitor Likely Cash Crisis

The efficient working of companies, among other factors, depends on the availability of funds to keep the operations going.

 

A key financial parameter that is used for assessing a company's operational efficiency and financial agility is debtor days.

 

All sales contracts state the payment terms within an agreed-upon timeframe. Some companies offer incentives to customers for early bill settlement, similar to the discount offered by electricity distribution companies to consumers for paying the bill before the due date.

 

Debtor days are calculated by dividing the average receivables by sales and multiplying the result by 365.

 

This indicator tells you how quickly a firm is getting payments from customers.

 

Impact of Debtor Days on Cash Flow

 

High debtor days often signal significant cash tied up in accounts receivable, potentially leading to cash flow challenges.

 

But if debtor days decrease, more cash can flow in, improving working capital and ensuring solid financial stability. 

 

It's crucial for businesses to monitor their receivables by ensuring that sales invoices are paid on time.

 

Paying for raw materials, wages, or even footing the electricity bill - all these have to be paid without resorting to raising debt.

 

Debtor days are a key performance indicator, revealing a company's ability to convert sales into cash efficiently.

 

A discrepancy between profit after tax and cash flow from operations can indicate inefficiencies in receivables management.

 

Investors should be wary of companies where cumulative cash flow from operations trails cumulative net profit over an extended period. This can signify an overreliance on debt to bridge operational funding gaps.

 

When customers' payments are late, companies may be forced to look at borrowings to bridge the gap.

 

In such a situation, the company's credit rating could also come under pressure if it struggles to meet debt commitments due to a lack of cash.

 

What Causes Debtor Days To Rise?

 

Certain scenarios inherently result in prolonged debtor days.

 

Companies with products that have low bargaining power are compelled to extend generous credit terms to maintain customer loyalty.

 

That is why many commodity companies spend money on marketing and advertising to build brand loyalty.

 

Similarly, disputes over product quality or project milestones can delay payments, inadvertently inflating debtor days.

 

Analysing industry norms can give investors a benchmark for evaluating a company's debtor days.

 

Variances in payment collection efficiency, influenced by market position and product differentiation, highlight the importance of contextual analysis.

 

Comparing a company's debtor days against its peers offers valuable insights into its credit management practices and competitive standing.

 

While debtor days are a crucial parameter to monitor, also check the debtor days of peer companies to see if they are peculiar to any particular sector.

 

This metric reflects a company's financial acumen and strategic approach to market challenges.

 

Many companies negotiate longer credit periods with vendors to manage higher debtor days without straining cash flow.

 

What Should Investors Watch?

 

Investors can safeguard against undue risks by investing in companies with efficient credit management and robust cash flow mechanisms.

 

The Securities and Exchange Board of India requires listed companies to give details of their cash flow along with results, once every six months along with their results.

 

High debtor days can also because of fake sales being booked by the company to inflate the numbers.

 

This discrepancy leads to an inflated profit and loss statement without a corresponding increase in operational cash flow in the cash flow statement.

 

Do your homework before jumping to any conclusions.

 

While a one-off rise in Debtor Days can be due to market conditions, a consistent rise of this parameter is a red flag of an impending fraud.

 

As you refine your investment strategy, remember the significance of debtor days as a barometer for financial health and operational efficiency.

 

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