What is the 'Average Collection Period'
The average collection period is the approximate amount of time that it takes for a business to receive payments owed in terms of accounts receivable. The average collection period is calculated by dividing the average balance of accounts receivable by total net credit sales for the period and multiplying the quotient by the number of days in the period.
Days = Total amount of days in period
AR = Average amount of accounts receivables
Credit Sales = Total amount of net credit sales during period
BREAKING DOWN 'Average Collection Period'The average collection period represents the average number of days between the date a credit sale is made and the date payment is received from the credit sale. The average balance of accounts receivable is calculated by adding the beginning balance in accounts receivable and ending balance in accounts receivable and dividing the total by 2. When calculating the average collection period for an entire year, 360 may be used as the number of days in one year for simplicity.
Example of an Average Collection Period
A company has an average accounts receivable balance for the year of $10,000. Total net sales during this period equal $100,000. The average collection period would be 36.5 days (($10,000/$100,000)*365). This indicates that it takes just over 36 days to collect an account receivable.
Accounts Receivable Turnover
The average collection period is closely related to the accounts turnover ratio. The accounts turnover ratio is calculated by dividing total net sales by the average accounts receivable balance. In the previous example, the accounts receivable turnover would be 10 ($100,000 / $10,000). The average collection period can be calculated using the accounts receivable turnover by dividing the number of days in the period by the metric. In this example, the average collection period is the same as before at 36.5 days (365 days / 10).
In general, a lower average collection period is more favorable than a higher average collection period. A low average collection period indicates that the organization is collecting payment faster. However, this may be an indication that its credit terms are too strict, and customers may seek suppliers or service providers with more lenient payment terms.
As a standalone figure, the average collection period does not hold much value; instead, it is a metric best suited for comparison over time. A company experiences the greatest benefit from calculating the average collection period by maintaining the metric over time and searching for trends. In addition, the calculation may be compared to competitors and other businesses in the industry. Similar companies should produce similar financial metrics, so the average collection period can be used as a benchmark against another company's performance.
Monitoring Collection Period
A company should compare the average collection period to 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 affects the organization's cash flows.