The industries in which average collection period – the median amount of time necessary for a business to recover its receivables – is most important are those in which receivables make up the greatest portion of cash flows. These industries include banks and financial institutions, car dealerships, retail, construction and professional services. However, there are many other industries for which it is important.
Average Collection Period
A company's average collection period reflects the efficiency of accounts receivable management practices. It can be calculated by taking total credit sales and dividing that by the multiple of average receivables and number of days in the time period.
For example, suppose a company had total net credit sales of $250,000 in a year (represented as 365 days). Its average accounts receivable balance over that same period was $75,000. The average collection period equation can be set up like this:
Average Collection Period=250,000365×75,000=109.5
In this case, the average collection period is 109.5 days. The smaller this number, the more efficient an analyst could interpret their receivables management.
Types of Industries and Accounts Receivable Management
All companies would like to have a reduced average collection period on their receivables. Not every company interacts with credit sales and receivables in the same way, however.
Take the agriculture and forestry industry, for example. The products that this industry produces tend to be sold in bulk to large retailers or governments. These companies tend to have established relationships and great contractual recourses. The average collection period can afford to be a little longer in these cases, even if it is just as important as any other industry.
Construction and real estate companies rely on sufficient cash flow to buy materials and deploy labor towards projects that don't immediately generate income. A property normally only generates income after the building is completed. This puts a lot of emphasis on correct and timely billing. Moreover, rental real estate tends to run into constant cash flow need; poor receivables management cannot be tolerated for long.
Medical and health care companies have a unique challenge, since a great number of medical payments are made through third parties. This creates a great moral hazard among the recipients of medical services, since their consumption does not bear the full cost of service provision. Providers of health care must be on top of collections to keep the doors open for non-paying customers.
The wholesale distribution sector is infamous for poor collection practices and delinquency among its customers. Even if average collection periods may be smaller than many other industries, the margins for wholesale distributors are so small that smaller periods may still be less efficient.
No industry considers collections more important than a bank, however. Banks generate much of their income through interest-generating loans. Poor collection practices would quickly spell doom for a bank (or another financial lender) with a huge portfolio of mortgages or car loans.