Trade debtors amount, in the Balance Sheet, is SLIM if the collection period is less than two months. Three months period is considered bulky and barely acceptable. For a collection period more than three months, the management is having problem in collecting debts. Investors, run!
Collection period formula:
Trade debtors / Sales (Turnover) per annum x 365, OR
Trade debtors / Sales (Turnover) per quarter x 92
This is the same for stocks. Stocks amount is SLIM if the stock turnover period is within two months. Three months period is considered bulky, low, slow and barely acceptable. For a stock turnover period more than three months, the company is having obsolete stocks that nobody wants, having a big problem in production flow and/or having a bad purchasing process.
Stock turnover period formula:
Stocks / Cost of sales per annum x 365, OR
Stocks / Cost of sales per quarter x 92
* Sometimes there is no data on cost of sales. The alternative is estimated cost of sales = Sales (turnover) x (100% - profit margin%)
The longer the period, the slower or lower the stock turnover and the higher chances of obsolete stocks, bad stock management or bad production flow.
Accounting text books make no effort in differentiating stocks and trade debtors from cash in measuring liquidity. Therefore, when we were students we couldn't figure out whether bulky current assets is good or bad. Now the answer is clear: Bulky Stocks and Trade Debtors are BAD for business. Bulky cash has no harm.
Illustration 1
Consider this fact:
1. Debtors collection period = 3 months
2. Stocks turnover period = 3 months
3. Creditors payment period = 3 months
Observations:
This company managed to get their creditors to finance their stocks. However, the company still needs to finance its trade debtors equivalent to 3 months of sales.
Illustration 2
Consider this fact:
1. Debtors collection period = 0.5 month
2. Stocks turnover period = 1 month
3. Creditors payment period = 3 months
Observations:
This company managed to get their creditors to finance their stocks and debtors. It is reflected in their Balance Sheet that the company doesn't have to spend a single penny in operation. Good business.
AEON Co. (M) Bhd (Jaya Jusco) is the perfect example of Illustration 2. On their supermarket retail business, AEON has no debtors (cash business), high stock turnover (less than one month) and get their suppliers (Creditors/ Payables in Balance Sheet) to give 3 months payments period. The suppliers is financing AEON's stocks, debtors, cash and part of their capital expenditure. Check out their balance sheet here, AEON has negative S+TD-TC. This kind of business, that let the creditors to fund its operation, is the extreme of the above example. But the idea should be illustrated well.
By refusing to provide and charge out obsolete stocks and/or bad and doubtful debts to income statements as expenses, the management is manipulating profit. Naturally the Balance Sheet looks bulky.
The worst case scenario is that the management decides to reverse previously provided provisions, therefore increase the stocks and/or debtors amount in the Balance Sheet and create fake profit. This shall reflect as a big positive movement in S+TD-TC.
In a nutshell, bulky S+TD-TC is BAD and slim S+TD-TC is GOOD. Positive movement (increase) in S+TD-TC is BAD. Negative movement (decrease) in S+TD-TC is GOOD.
The exception is revenue growth. Even in such a case, debt collection period and stock turnover period should not deteriorate.
Back to Step 3: inventories/stocks, trade debtors and trade creditors.
