What Is an Average Collection Period?

Average collection period is 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 make sure♒ they have enough cash on hand to meet their financial obligations𝕴.

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 澳洲幸运5官方开奖结果体彩网:cash flows.

How Average Collection Periods Work

Accounts receivable (AR) is a business term used to describe money that entities owe to a company when they purchase goods and/or services. Companies normally make these sales to their customers on credit. AR is listed on corporations’ 澳洲幸运5官方开奖结果体彩网:balance sheets as current assets and measures their 澳洲幸运5官方开奖结果体彩网:liquidity. As such, they indicate their ability to pay off their༺ short-ter🍨m debts without the need to rely on additional cash flows.

The average collection period is an accounting metric used to represent the average number of days between a credit sale date and the date when the purchaser remits payment. A company’s average collection period is indicative of the 澳洲幸运5官方开奖结果体彩网:effectiveness of its AR man🌊agement practices. Businesses must be able t👍o manage their average collection period to operate smoothly.

A lower average collection period is generally more favorable than a higher one. A low average collection period indicates that the organization collects payments faster. However, this may also mean that the company’s credit terms are too strict. Customers who don’t find their 澳洲幸运5官方开奖结果体彩网:creditors’ terms very friendly may choose to seek suppliers or service providers with more lenient payment terms.

Formula for Average Collection Period

Average collection period is calculate✱d by dividing a company’s average accounts receivable (AR) balance by its net credit sales for a specific perioꦉd, then multiplying the quotient by 365 days.

Average Collection Period = 365 Days * (Average Accounts Receivables / Net Credit Sales)

Alternatively and more commonly, the average collection period is denoted as the number of days of a period divided by the 澳洲幸运5官方开奖结果体彩网:receivables turnover ratio. The formula below is also referred to as �ဣ�the days sales in receivable ratio.

Average Collection Period = 365 Days / Receivables Turnover Ratio

The average receivables turnover is the average accounts receivable balance divided by 澳洲幸运5官方开奖结果体彩网:net credit sales. The formula below is a more concise way of writing it.

Average Accounts Receivables

For the formulas above, average accounts receivable is calculated by taking the average of the beginning and ending balances of a given period. ꦺMore sophisticated accounting reporting tools may be able to automate a company’s average accounts receivable over a given period by factoring in daily ending balances.

When analyzing average collection period, be mindful of the 澳洲幸运5官方开奖结果体彩网:seasonality of the accounts receivable balances. For exam♓ple, analyzing a peak month to a slow month may result in a very inconsistent average accounts receivable balance ⛎that may skew the calculated amount.

Net Credit Sales

Average collection period also relies on net credit sales for a period. This metric should exclude cash▨ sales (as those are not made on credit and therefore do not have a collection period).

In addition to being limited to only credit sales, net credit sales exclude residual transactions that impact and often reduce sales amounts. This includes any discounts awarded to customers, 澳洲幸运5官方开奖结果体彩网:product recalls or returns, or items reissued under warranty.

Importance of Average Collection Period

The average collection period boils down to a single number. However, it has many different uses and communicates several pieꩵces of information.

• It tells you how quickly debts are collected. This is important because a credit sale is not fully completed until the company has been paid. Until cash has been collected, a company has yet to reap the full benefit of the transaction.
• It tells you how strict credit terms are. This is important, as credit terms that are too strict may scare clients away. On the other hand, credit terms that are too loose may attract customers looking to take advantage of lenient payment terms.
• It tells you how competitors are performing. This is important because all figures needed to calculate the average collection period are available for public companies. This gives deeper insight into what other companies are doing and how a company’s operations compare.
• It tells you early signals of bad allowances. This is important because as the average collection period increases, more clients are taking longer to pay. This metric can be used to signal to management to review its outstanding receivables at risk of being uncollected to ensure clients are being monitored and communicated with.
• It tells you of a company’s short-term financial health. This is important because without cash collections, a company will go 澳洲幸运5官方开奖结果体彩网:insolvent and lack the liquidity to pay its short-term bills.

How to Use Average Collection Period

The average collection period does not hold much value as a stand-alone figure. Instead, you can get more out of its value by using it as a comparative tool.

The best way that a company can benefit is by consistently calculating its average collection period and using it over time to search for trends within its own business. The average collection period may also be used to compare one company with its competitors, either individually or grouped. Similar companies should produce simi🐟lar financial metrics, so the average collection period can be used as a benchmark against another comp💫any’s performance.

Companies may also compare the average collection period with the credit terms extended to customers. For example, an average collection period of 25 days isn’t as concerning if invoices are issued with a net 30 due date. However, an ongoing evaluation of the outstanding collection period directly affect♐s the organization’s cas🔥h flows.

Example of Average Collection Period

As noted above, the average collection period is calculated by dividing the average balance of accounts receivable (AR) by total net credit sales for the period, then multiplying the quotient 𒊎by the number of days in the perio🎀d.

Let’s say a company has an average AR balance for the year of $10,000. The total🎐 net sales that the company recorded during this period was $100,000. We would use the following average collection period formula to calculate the period:

 ($10,000 ÷ $100,000) × 365 = Average Collection Period

The average coll⛄ection period, therefore, would be 36.5 days. This is not a bad figure, considering most companies collect within 30 days. Collecting its receivables in a relatively short and reasonable period of time gives the company time to pay off its obligations.

If this company’s average collection period was longer—say, more than 60 days—then it would need to 澳洲幸运5官方开奖结果体彩网:adopt a moಞre aggressive collectionℱ policy to sho🦩rten that time frame.📖 Otherwise, it may find itself falling short when it comes to paying its own debts.

Accounts Receivable (AR) Turnover

The average collection period is closely related to the accounts turnover ratio, which is calculated by dividing total 澳洲幸运5官方开奖结果体彩网:net sales by the average AR balance.

Using the previous example, the AR turnover is 10 ($100,000 ÷ $10,000). The average collection period can also be calculated by dividing the numbe🐻r of days in the period by the AR turnover. In this example, the average collection period is the same as before: 36.5 days.

 365 days ÷ 10 = Average Collection Period

Collections by Industries

Not all businesses deal with credit and cash in the same way. Although cash on hand is important to every business, 澳洲幸运5官方开奖结果体彩网:some rely more on their cash flow than others.

For example, the banking sector relies heavily on receivables because of the loans and mortgages that it offers to consumers. As it relies on income generated from these products, banks must have a short 澳洲幸运5官方开奖结果体彩网:turnaround time for receivables. If they have lax collection procedures and policies in place, then incomeꦇ would drop, causing financial harm.

澳洲幸运5官方开奖结果体彩网:Real estate and construction companies also rely on steady cash flows to pay for labor, services, and suppli♔es. These industries don’t necessarily generate income as readily as banks, so it’s important that those working in these industries bill at appropriate intervals, as sales and construction take time and may be subject to delays.

The Bottom Line

T꧙he average collection period is the average number of days it takes for a credi🅰t sale to be collected. During this period, the company is awarding its customer a very short-term loan. The sooner the client can collect the loan, the earlier it will have the capital to use to grow its company or pay its invoices.

While a shorter average collection period is often better, it also may indicate that t𝄹he company has credit terms that are too strict, whic💫h may scare customers away.