What Is an Average Collection Period?
Average collection period refers to the amount of time it takes for a business to receive payments owed by its clients in terms of accounts receivable (AR). Companies use the average collection period to ensure they have enough cash on hand to meet their financial obligations. The average collection period is an indicator of the effectiveness of a firm’s AR management practices and is an important metric for companies that rely heavily on receivables for their cash flows.
Key Takeaways
- Ensures liquidity: The average collection period helps companies ascertain if they have adequate cash to meet short-term liabilities.
- Measures effectiveness: It evaluates the efficiency of a company’s AR management practices.
- Faster collections: A lower average collection period suggests quick payment collections.
How Average Collection Periods Work
Accounts receivable describes money that entities owe to a company for goods and services purchased on credit. AR is listed on corporations’ balance sheets as current assets and measures their liquidity. The average collection period is the average time between a credit sale date and the date a customer payment is received. Effective AR management is crucial for business operations.
A low average collection period is generally favorable but strict credit terms can drive customers away. Balancing efficient collections with flexible credit terms is key.
Formula for Average Collection Period
The average collection period can be calculated using one of two formulas:
- Primary Formula
Average Collection Period = 365 Days * (Average Accounts Receivables / Net Credit Sales)
- Receivables Turnover Ratio Formula
Average Collection Period = 365 Days / Receivables Turnover Ratio
Average Accounts Receivables
To find the average accounts receivable, calculate the average of the beginning and ending balances within a specified period.
Net Credit Sales
Net credit sales should exclude cash sales, discounts, product recalls, and warranty re-issues.
Importance of Average Collection Period
Understanding the average collection period yields insights into several aspects of a company’s financial health:
- Debt collection: Evaluates efficiency in collecting debts.
- Credit terms: Indicates the stringency of credit policies.
- Competitor analysis: Measures performance relative to peers.
- Early warnings: Identifies potential bad debts early.
- Financial health: Signals short-term liquidity status.
How to Use Average Collection Period
Employ the average collection period as a comparative tool rather than a standalone figure. Consistently calculate it over time to track business trends and compare it against competitor benchmarks.
Comparing with Credit Terms
Analyze the average collection period relative to your invoicing terms. For example, an average collection period of 25 days is acceptable if invoices are due in 30 days. However, routinely high days indicate the need to revisit collection policies.
Example of Average Collection Period
Suppose a company’s average AR balance for the year is $10,000, with total net sales of $100,000. The average collection period can be calculated as:
1($10,000 ÷ $100,000) × 365 = 36.5 days
If this period exceeds 60 days, a more aggressive collection strategy may be needed to avoid cash flow issues.
Accounts Receivable (AR) Turnover
AR turnover is the total net sales divided by the average AR balance. Continuing with the previous example, the AR turnover would be:
1$100,000 ÷ $10,000 = 10
Therefore, the average collection period remains:
1365 days ÷ 10 = 36.5 days
Collections by Industries
Different industries manage credit and cash differently. For example, the banking sector necessitates quick receivables turnaround due to reliance on loan income, while real estate and construction manage cash flows with appropriate billing intervals due to extended project timelines.
Why Is the Average Collection Period Important?
The average collection period highlights the efficiency of accounts receivable practices, essential for understanding cash flow and financial health. Managing this metric ensures there is sufficient cash on hand to meet obligations.
How Is the Average Collection Period Calculated?
The period is calculated by dividing the average accounts receivable balance by total net credit sales, then multiplying by the number of days in the period. For example:
1($10,000 ÷ $100,000) × 365 = 36.5 days
Why Is a Lower Average Collection Period Better?
A lower period is often preferred as it indicates faster collections, though overly stringent terms can alienate customers.
How Can a Company Improve its Average Collection Period?
Companies can improve their average collection period by:
- Stricter credit terms: Limiting the number of days an invoice remains outstanding.
- Selective credit offering: Increasing cash sales by restricting credit sales.
- Discount incentives: Offering payments discounts for early settlement.
Conclusion
The average collection period is a vital metric that reflects the efficiency of receivables management. While a shorter collection period is generally favorable, striking the right balance with credit terms is essential to maintain customer satisfaction and robust cash flows.
Related Terms: Receivables Turnover Ratio, Net Credit Sales, Liquidity, Balance Sheet.
References
- Business Development Bank of Canada. “Average Collection Period Ratio”.
- Robert J. R. Folles. How to Keep Score in Business Accounting and Financial Analysis for the Non-accountant. FT Press, 2012, Pages 58-62.
- Business Development Bank of Canada. “Average Collection Period (Receivables Turnover)”.
