What Is an Average Collection Period?
The term 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. But there is a downside to this, as it 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.
The average balance of AR is calculated by adding the opening balance in AR and ending balance in AR, then dividing that total by two. When calculating the average collection period for an entire year, 365 may be used as the number of days in one year for simplicity. More detailed information on this is outlined below.
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.
How to Calculate the 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.
But 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.