What Is the Average Collection Period?
The average collection period is the amount of time it takes for a business to receive payments owed by its clients in terms of accounts receivable (AR). Companies calculate the average collection period to make sure they have enough cash on hand to meet their financial obligations.
The average collection period is calculated by dividing the average balance of accounts receivable by total net credit sales for the period and multiplying the quotient by the number of days in the period.
Average collection periods are most important for companies that rely heavily on receivables for their cash flows.
Average collection periods are important for businesses that rely heavily on their cash flow.
Understanding the Average Collection Period
The average collection period represents the average number of days between the date a credit sale is made and the date the purchaser pays for that sale. A company's average collection period is indicative of the effectiveness of its accounts receivable management practices. Businesses must be able to manage their average collection period in order to ensure they operate smoothly.
A lower average collection period is generally more favorable than a higher average collection period. A low average collection period indicates the organization collects payments faster. There is a downside to this, though, as it may indicate its credit terms are too strict. Customers may seek suppliers or service providers with more lenient payment terms.
The average balance of accounts receivable is calculated by adding the opening balance in accounts receivable (AR) and ending balance in accounts receivable and 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.
Average Collection Period
Example of an Average Collection Period
Let's say a company has an average accounts receivable balance for the year of $10,000. The total net sales the company recorded during this period was $100,000. So to calculate the average collection period, we use the following formula:
(($10,000 ÷ $100,000) x 365).
The average collection period, therefore, would be 36.5 days—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, it would need to adopt a more aggressive collection policy to shorten that time frame.
- The average collection period is the amount of time it takes for a business to receive payments owed by its clients.
- Companies calculate the average collection period to ensure they have enough cash on hand to meet their financial obligations.
- Low average collection periods indicates organizations collect payments faster.
Accounts Receivable Turnover
The average collection period is closely related to the accounts turnover ratio. The accounts turnover ratio is calculated by dividing total net sales by the average accounts receivable balance.
In the previous example, the accounts receivable turnover is 10 ($100,000 ÷ $10,000). The average collection period can be calculated using the accounts receivable turnover by dividing the number of days in the period by the metric. In this example, the average collection period is the same as before at 36.5 days (365 days ÷ 10).
The average collection period does not hold much value as a standalone figure. Instead, you can get more out of its value by using it as a comparative tool.
The best way a company can benefit is by consistently calculating its average collection period, and using this figure 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 to 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.
Collections by Industries
Not all businesses deal with credit and cash, or receivables 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 it offers to consumers. Since 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, income would drop, meaning financial harm.
Real estate and construction companies also rely on steady cash flows in order 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.