Accrual accounting is a business standard under generally accepted accounting principles (GAAP) that makes it possible for companies to sell their goods and services with credit. Accrual accounting calls for the booking of revenue at the time of sale. While it is expected to help increase sales for a firm, it’s a concept that creates a core element of complexity for financial statement reporting.
Most modern businesses use accrual accounting, offering their customers the option to buy now and pay later. This process is typically done through invoicing which requires a company to set collection period parameters and deploy specific receivables procedures. While a "buy now, pay later" model theoretically seeks to increase sales, the downside is it delays and creates some uncertainty for cash flow payments. As such, it can become more difficult to finance day-to-day operations or make future investments.
To measure the number of days it takes for a company to receive payments for its sales, companies and analysts primarily use the average collection period metric. The average collection period is the primary industry standard for evaluating a company’s accrual accounting procedures and assessing its expectations for cash flow management. The average collection period metric may also be called the days to sales ratio or the receivable days. Generally, the average collection period is an important internal metric used in the overall management of a company’s finances.
Calculating the Average Collection Period
The average collection period is a granular metric. As discussed, it represents the average number of days it takes for a company to receive payment for its sales. There can be a few variations of the formula.
One of the simplest ways to calculate the average collection period is to start with receivables turnover which is calculated by dividing sales over accounts receivable to determine the turnover ratio.
From there the number of days in the period is divided by the turnover ratio. This arrives at the average collection period in days.
Receivables Turnover=Accounts ReceivableSalesDays=365Turnover
There are a few considerations when calculating this metric. Mainly, averages can be key. The receivables turnover can use the total accounts receivable at the end of a period or the average throughout the period. Investors and analysts may not have access to the average receivables so they would need to use the ending balance or an average of four quarters for a full year. Also, this metric is an average across a specified number of days, so it is not an exact measure and will be more broadly skewed with the number of days involved. Most often it is calculated for an entire year.
An alternative means of calculating the average collection period is to multiply the total number of days in the period by the average balance in accounts receivable and then divide by sales for the period.
Average Collection Period
Cash Flow and Average Collection Period
The average collection period is used a few different ways to measure cash flow performance. Generally speaking, companies want to minimize their average collection period. Overall shorter collection periods increase liquidity and generate better cash flow efficiency. Companies use the average collection period as a key aspect of operating cash flow management, determining the optimal collection period for their company’s needs. Oftentimes, companies will also consider accounts receivable write-offs in conjunction with average collection period days for a broader assessment. Creditors may also follow average collection period data and may even include threshold requirements for maintaining credit terms.