You understand the significance of metrics in your accounts receivable and collections management. You’ll need a yardstick to determine how effective your efforts are.
Accounts receivable metrics can reveal this information. Of course, there are numerous metrics to pick from, so you must be selective about the ones you measure. You’re already keeping track of your accounts receivable turnover percentage and probably wondering what your average collection period ratio is. Let’s go over the details of the average collection period of your account receivables, the formula, and calculations.
What is Average Collection Period?
The average collection period is the length of time it takes for a corporation to collect its accounts receivable (AR). It refers to the average time it takes for the company to receive money owed to it by clients or consumers. It must be managed to ensure that a company has adequate cash on hand. This is to enable it to meet its short-term financial obligations.
To be clear, the average collection period is a calculation of the average number of days between the date they make the transaction on credit) and the date the buyer submits payment or the date the company gets payment from the buyer.
Importance of Average Collection Period
#1. Preserve liquidity
Clearly, receiving payment for goods or services that are given promptly is critical for a business. It allows the company to maintain a level of liquidity. This allows it to pay for immediate needs and obtain a sense of when it might be able to make larger acquisitions.
#2. Budget for future expenses and set aside money for them.
The average collection period figure is particularly crucial from a timing standpoint. It can assist a company in developing an effective plan for covering costs and arranging possible investments to further growth.
So, the shorter the average collection duration, for obvious reasons, the better for the company. It signifies that a company’s customers pay their invoices more quickly. Another way to look at it is that a shorter average collection duration indicates that the company receives payment more quickly.
A short collection duration may not always be advantageous because it may merely indicate that the organization has rigorous payment policies in place. The rules may be appropriate for some clients. Stricter collection criteria, on the other hand, may push away certain clients, prompting them to hunt for organizations that offer the same goods or services but have more flexible payment restrictions or better payment choices.
Formula for the Average Collection Period
Let’s look at how a corporation determines its typical collection duration. In most cases, they measure the average collecting period in days. The corporation must compute its annual average balance of accounts receivable and divide it by total net sales. The formula for the average collection period is as follows:
Consider the following example to further demonstrate the formula of the average collection period in action. Assume Company ABC has a yearly accounts receivable balance of $25,000. The company made $200,000 in total net sales that year.
The first step in determining the average collection period for the company from the accounts receivable is to split $25,000 by $200,000. Because the computation is to establish the average collecting period for the year, the quotient must then be multiplied by 365. In our case, the average collection period computation looks like this:
(25,000 / 200,000) * 365 = 45.6
It suggests that for the entire year, Company ABC’s average collecting period is around 46 days. When you consider that most businesses aim to collect money within 30 days, it seems a little high.
The average collection period figure for the company can signify a few different things. the average collection period could imply that the company isn’t as efficient as it should be when it comes to collecting accounts receivable. However, the figure could also indicate that the corporation offers more flexible payment arrangements for outstanding invoices.
Average Collection Period Calculations
You get the average collection period by dividing the average AR balance by the total net credit sales for the period and then multiplying the quotient by the number of days in the period. Assume a company’s average AR balance for the year is $10,000. During this time period, the company’s total net revenues were $100,000. To compute the period, we would use the following average collection period formula:
($10,000 ÷ $100,000) × 365 = Average Collection Period
As a result, the average collection duration would be 36.5 days—not a bad statistic since most businesses collect within 30 days. Collecting receivables in a relatively short—and reasonable—time frame allows the corporation to pay off its commitments ie a short average collection period.
If this company’s typical collection duration was greater than 60 days, it would need to implement a more aggressive collection procedure to reduce that time frame.
Turnover of Accounts Receivable (AR)
The accounts turnover ratio, we get by dividing total net sales by the average accounts receivable balance, is strongly tied to the average collection period. The AR turnover in the preceding case is 10 ($100,000 $10,000). You can alternatively compute the average collection period by dividing the number of days in the period by the AR turnover. The average collection period in this scenario is the same as in the previous one: 37.6 days
365 days ÷ 10 = Average Collection Period
Comparability
As a stand-alone metric, the average collection period has little meaning. Instead, you may maximize its utility by using it as a comparison tool.
The easiest way for a firm to benefit is to calculate its average collection period regularly and use it to seek trends within its own business over time. One can also use the average collection period to compare one company to its competitors, whether individually or collectively. Similar companies should generate comparable financial measures, so we can use the average collection time as a benchmark against the performance of another company.
Companies might also compare the average collection period to the credit terms offered to their consumers. For example, if you issue bills with a net 30 due date, an average collection delay of 25 days isn’t as problematic. However, a continual assessment of the outstanding collecting period has a direct impact on the organization’s financial flows.
Collections by Industries
Not every firm handles credit and cash in the same way. Although cash on hand is vital for all businesses, some rely more on it than others.
For example, the banking industry is significantly reliant on receivables due to the loans and mortgages it provides to customers. Banks must have a quick turnaround time for receivables because they rely on the income generated by these products. Income would fall if they had slack collection procedures and standards in place, creating financial loss.
Real estate and construction firms rely on consistent cash flows to pay for labor, services, and materials as well. Because these industries do not create cash as quickly as banks, employees working in them must bill at suitable intervals, as sales and construction take time and may be vulnerable to delays.
Changes in the Average Collection Period: How to Interpret Them
An increase in the average collection period may indicate one of the following conditions:
#1. Credit policy relaxation.
Management has opted to extend more credit to clients, maybe to boost sales. This could also imply that certain customers are being given a longer grace period before having to settle overdue debts. This is especially typical when a small business wishes to sell to a large retail chain, which can guarantee a significant increase in sales in exchange for long payment terms.
#2. The economy is deteriorating.
Customers’ cash flows may be impacted by general economic conditions, prompting them to postpone payments to their suppliers.
#3. Collection attempts have been reduced.
There could be a decrease in financing for the collections department or an increase in worker turnover. In either situation, collections receive less attention, resulting in a rise in the number of receivables outstanding.
A decrease in the average collection period could be caused by any of the following conditions:
#1. Credit policies will be tightened.
Management may limit credit to customers for a variety of reasons, including anticipating a fall in economic conditions or not having adequate working capital to support the existing level of accounts receivable.
#2. Terms have been condensed.
Customers may have been given shorter payment terms by the company.
#3. Collection efforts have been stepped up.
Management may have decided to boost the collections department’s staffing and technological support, which should result in a reduction in the amount of past-due accounts receivable.
The Average Collection Period Limitations
It is prudent to use caution when interpreting the average collection period ratio.
For one thing, the ratio must be evaluated in comparison to being significant. Is the company’s capacity to collect receivables rising (the average collection period ratio is lower) or deteriorating in comparison to previous years? (the average collection period ratio is higher). If it is dropping in contrast, it indicates that your accounts receivable are losing liquidity, and you may need to take proactive measures to reverse this trend.
You should also compare your company’s credit policy to the average number of days from credit sale to balance collection to determine how well your company is doing. If the average collection period is 45 days, yet the firm’s credit policy requires it to recover receivables in 30 days, there is an issue.
However, if the average period is 45 days and the declared credit policy is net 10 days, the situation is far worse; your clients are not adhering to the credit agreement conditions. This necessitates an examination of your company’s credit policy and the implementation of corrective steps. The steps may include tightening credit requirements or making credit conditions more obvious to your clients.
Average Collection Period FAQ’s
How do you calculate average collection period?
This necessitates an examination of your company’s credit policy and the implementation of corrective steps, such as tightening credit requirements or making credit conditions more obvious to your clients.
What does a low average collection period mean?
It signifies that a company’s customers pay their invoices more quickly. Another way to look at it is that a shorter average collection duration indicates that the company receives payment more quickly.
How do you analyze debtors collection period?
Divide the amount owing by trade debtors by the annual sales on credit and multiply by 365 to get the debtor collection period ratio.
