What Is an Average Collection Period?
Average collection period refers to 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 obligations. 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 cash flows.
- The average collection period refers to the length of time a business needs to collect its accounts receivables.
- Companies calculate the average collection period to ensure they have enough cash on hand to meet their financial obligations.
- The average collection period is determined by dividing the average AR balance by the total net credit sales and multiplying that figure by the number of days in the period.
- This period indicates the effectiveness of a company's AR management practices.
- A low average collection period indicates that an organization collects payments faster.
How Average Collection Periods Work
Accounts receivable 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' balance sheets as current assets and measures their liquidity. As such, they indicate their ability to pay off their short-term 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 effectiveness of its AR management practices. Businesses must be able to 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 mean that the company's credit terms are too strict. Customers who don't find their 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 calculated by dividing a company's average accounts receivable balance by its net credit sales for a specific period, 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 receivables turnover ratio. The formula below is also used referred to as the days sales receivable ratio.
Average Collection Period = 365 Days / Receivables Turnover Ratio
The average receivables turnover is simply the average accounts receivable balance divided by net credit sales; the formula below is simply a more concise way of writing the formula.
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 seasonality of the accounts receivable balances. For example, analyzing a peak month to a slow month by 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, product recalls or returns, or items re-issued under warranty.
When calculating average collection period, ensure the same timeframe is being used for both net credit sales and average receivables. For example, if analyzing a company's full year income statement, the beginning and ending receivable balances pulled from the balance sheet must match the same period.
Importance of Average Collection Period
Average collection period boils down to a single number; however, it has many different uses and communicates a variety of important information.
- It tells how efficiently 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 is yet to reap the full benefit of the transaction.
- It tells how strict credit terms are. This is important as strict credit terms 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 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 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 of a company's short-term financial health. This is important because without cash collections, a company will go 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 together. Similar companies should produce similar financial metrics, so the average collection period can be used as a benchmark against another company’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 affects the organization’s cash flows.
The average collection period is often not an externally required figure to be reported. It is also generally not included as a financial covenant. The usefulness of average collection period is to inform management of its operations.
Example of Average Collection Period
As noted above, the average collection period is calculated by dividing the average balance of AR by total net credit sales for the period, then multiplying the quotient by the number of days in the period.
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 collection 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 adopt a more aggressive collection policy to shorten that time frame. Otherwise, it may find itself falling short when it comes to paying its own debts.
Accounts Receivable (AR) Turnover
Using the previous example, the AR turnover is 10 ($100,000 ÷ $10,000). The average collection period can also be calculated by dividing the number 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, 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 turnaround time for receivables. If they have lax collection procedures and policies in place, then income would drop, causing financial harm.
Real estate and construction companies also rely on steady cash flows to pay for labor, services, and supplies. 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.
Why Is the Average Collection Period Important?
The average collection period indicates the effectiveness of a firm’s accounts receivable management practices. It is very important for companies that heavily rely on their receivables when it comes to their cash flows. Businesses must manage their average collection period if they want to have enough cash on hand to fulfill their financial obligations.
How Is the Average Collection Period Calculated?
In order to calculate the average collection period, divide the average balance of accounts receivable by the total net credit sales for the period. Then multiply the quotient by the total number of days during that specific period.
So if a company has an average accounts receivable balance for the year of $10,000 and total net sales of $100,000, then the average collection period would be (($10,000 ÷ $100,000) × 365), or 36.5 days.
Why Is a Lower Average Collection Period Better?
Companies prefer a lower average collection period over a higher one as it indicates that a business can efficiently collect its receivables.
The drawback to this is that it may indicate the company's credit terms are too strict. Stricter terms may result in a loss of customers to competitors with more lenient payment terms.
How Can a Company Improve its Average Collection Period?
A company can improve its average collection period in a few ways. It can set stricter credit terms limiting the number of days an invoice is allowed to be outstanding. This may also include limiting the number of clients it offers credit to in an effort to increase cash sales. It can also offer pricing discounts for earlier payment (i.e. 2% discount if paid in 10 days).
The Bottom Line
The average collection period is the average number of days it takes for a credit 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, too strict of credit terms may scare customers away.