An average collection period shows the average number of days necessary to convert business receivables into cash. The degree to which this is useful for a business depends on the relative reliance on credit sales by the company to generate revenue – a high balance in accounts receivable can be a major liability.
In terms of business management, the average collection period is an extension of operating efficiency. Much like the receivables turnover ratio, the average collection period can be used in conjunction with liquidity ratios to highlight problems in cash flow or solvency.
Calculating the Average Collection Period
The standard formula for calculating an average collection period is the number of working days divided by the debtor receivables turnover ratio. For an annual average collection period, the number of working days is set to 365.
Clearly, the receivables turnover ratio is a major determinant of collection period efficiency.
The following formula can be used to find receivables turnover:
Receivables Turnover = (annual credit sales) / ((balance of starting receivables + balance of ending receivables) / 2)
What to Watch for When Analyzing Average Collection Period
Accounting ratios only rearrange business data and are mostly insignificant by themselves. The interpretations and uses of the average collection period vary between businesses and industries.
For example, suppose it takes a company an average of 25 days to turn receivables into cash. Whether this is good or bad depends on the credit terms, cash flow, relative industry standards and a host of other factors.
What time period should be examined for an average collection period? A company that sells and rents expensive skiing equipment might be best suited by adjusting its analysis for seasonal factors. Good proxies for effective time intervals should be apparent by reviewing industry standards.
It is common for a company to aim for an average collection period that is at least one-third lower than the expressed credit terms. If a credit agreement stipulates that the borrower has 45 days to pay, this would mean that the seller wants to collect within 30 days.
There could be meaningful differences within a single company. The data must be collected, arranged and presented in a way that tells a useful story.
A company experiences the greatest benefit from calculating the average collection period by maintaining the metric over time and searching for trends. This metric may also be compared to competitors and other businesses in the industry.
Why Average Collection Period Is Important
Effective accounts receivable management practices lead to timely customer collection. Tight credit policies have spill-over effects for the rest of a company's operations.
For example, improved cash flow numbers or liquidity ratios can make it easier for a company to obtain a low-interest commercial loan or attract new investors.
On the other hand, credit policies that are too tight tend to limit sales. A car dealer cannot have unreasonable credit terms, or else customers will choose competitors with more reasonable expectations.
Most companies aim for an average collection period that is lower than a marketable credit policy. They want to be able to offer accommodating terms to attract customers, and be able to collect efficiently as well.