Average Collection Period
The average collection period is a financial metric used to evaluate the efficiency of a company’s accounts receivable management. This metric represents the average number of days it takes for a company to collect payments from its customers after issuing an invoice.
A high average collection period may indicate that the company is having difficulty collecting payments, which can negatively impact its cash flow and profitability. On the other hand, a low average collection period suggests that the company has a good collection process in place, leading to improved cash flow and financial stability.
Why Is Average Collection Period Important?
The average collection period is a vital metric for businesses of all sizes as it provides valuable insight into the efficiency of their cash flow management and financial stability.
Itis a critical metric for businesses that extend credit to their customers. The metric measures the amount of time it takes for a company to receive payment from its customers after goods or services have been delivered. A shorter average collection period is generally considered more favorable because it means a business is receiving payment for its products or services more quickly.
- Impacts a company’s cash flow: A longer collection period means that a company has to wait longer to access the funds from its accounts receivable, which can negatively affect its ability to pay bills or invest in new projects. Conversely, a shorter collection period means that a company can more easily access the cash it needs to run its operations.
- Analyses credit terms: An extended average collection period can also indicate that there may be issues with a company’s credit policy, including overly lenient credit terms, inadequate credit checks, or too much reliance on customers with poor credit histories. It may also suggest that a company’s collection efforts are insufficient, and that it may need to implement more effective procedures for following up with slow-paying or delinquent customers.
How To Calculate the Average Collection Period
To calculate the average collection period, the first step is to obtain the accounts receivable turnover ratio. This ratio measures how many times a company can collect its average accounts receivable in a given period. To calculate this ratio, divide the net credit sales by the average accounts receivable:
Accounts Receivable Turnover Ratio = Net Credit Sales / Average Accounts Receivable
Once the accounts receivable turnover ratio is obtained, the next step is to convert it into days by dividing 365 (the number of days in a year) by the ratio. This will give you the average number of days it takes for a company to collect its outstanding accounts receivable.
Average Collection Period = Accounts Receivable Turnover Ratio x 365
For example, let’s say you are measuring the average collection period for a company over the course of a year.
The company had $500,000 in accounts receivable at the beginning of the year and $600,000 at the end of the year. Net credit sales for the year were $3,000,000.
Average Accounts Receivable = ($500,000 + $600,000) / 2 = $550,000
Accounts Receivable Turnover Ratio = $550,000 / $3,000,000 = 0.1833
Average Collection Period = 0.1833 x 365 = 66.95 days
Therefore, it takes the company, on average, 66.95 days to collect its outstanding accounts receivable.