Managing accounts receivable is a crucial aspect of running a successful business. A key metric in evaluating the effectiveness of your accounts receivable processes is the average collection period. The average collection period measures the average number of days it takes to collect payment from customers after a sale has been made. Monitoring this metric allows you to identify potential issues with collection efforts and cash flow difficulties.
In this article, we’ll explain what the average collection period is, why it’s important, and walk through the steps to calculate it. Having a firm grasp on your average collection period can help you set appropriate credit terms for customers, better anticipate cash inflows, and take action if collection issues arise. With some simple calculations, you can gain valuable insight into this critical component of your cash flow management.
What Is the Average Collection Period
The average collection period is an estimate of the number of days a company takes to collect payment on its credit sales. It is also known as the average days to collect receivables or the average days sales outstanding (DSO). The average collection period is calculated by dividing the accounts receivable balance by the average credit sales per day.
The formula for the average collection period is:
Average Collection Period = Accounts Receivable/ (Annual Credit Sales/360 days)
Or
Average Collection Period = Accounts Receivable/ (Net Credit Sales/Number of Days)
Where:
- Accounts Receivable is the ending accounts receivable balance.
- Annual Credit Sales is the total credit sales for the year.
- Net Credit Sales are total credit sales for the period measured.
- The number of Days is the number of days in the period measured.
The average collection period measures how quickly a company collects cash from its credit customers. A shorter collection period indicates more efficient credit and collections policies, while a longer period could indicate problems in receivables management.
Importance of Calculating the Average Collection Period
Calculating your average collection period is crucial for several reasons. It ensures you have adequate cash flow to meet financial obligations. A longer collection period strains cash reserves. Monitoring the metric also maintains visibility on liquidity levels and creditworthiness. Any upward trend could signal impending issues. The average collection period serves as an important marker of overall financial performance.
As it lengthens, profitability suffers from mounting uncollected receivables. It directly corresponds to how efficiently you issue credit, bill customers and collect payments. An increasing average collection period indicates problems in accounts receivable management. Tracking it regularly enables early identification of gaps that need improvement. With insight into cash conversion cycles, you can better manage liquidity and understand the health of your business.
How to Find Average Collection Period
To find the average collection period, follow these steps:
Determine the Accounts Receivables Turnover
Start by calculating the accounts receivables turnover ratio. This ratio is derived by dividing the total credit sales revenue by the accounts receivable balance. The accounts receivable balance represents sales that have not been paid for yet.
Calculate the Average Collection Period
Once you have determined the accounts receivables turnover ratio, proceed to calculate the average collection period. To do this, divide the average accounts receivable balance by the total sales revenue. Then, multiply the result by 365, as the timeframe is typically one year. The formula for calculating the average collection period is as follows:
Average Collection Period = (Accounts Receivable Balance / Total Sales Revenue) x 365
Calculate the Average Collection Period
Following the determination of the accounts receivables turnover ratio, proceed with calculating the average collection period. This involves dividing the average accounts receivable balance by the total sales revenue. Subsequently, multiply the obtained quotient by 365, as the timeframe conventionally spans one year. The formula for computing the average collection period can be expressed as:
Average Collection Period = (Accounts Receivable Balance / Total Sales Revenue) x 365
It’s crucial to tailor the formula to accommodate the specific requirements of your company, particularly if your business encounters seasonal variations in sales. Gaining a comprehensive understanding of the average collection period facilitates an accurate assessment of your company’s financial standing and the identification of areas for enhancement.
Interpret Your Average Collection Period
Upon deriving the average collection period, interpret the results to glean insights into your company’s financial condition. Your average collection period may fall into one of three classifications: average, low, or high.
- Low Collection Period: A low collection period is generally advantageous, signifying the efficient conversion of accounts receivable into cash flow. This suggests adept credit management practices and consistent payment collections from customers.
- High Collection Period: Conversely, a high collection period denotes sluggish payment collections, which may present challenges in cash flow management. While this could be attributed to customer payment tendencies, it may also indicate lenient credit policies. Companies encountering high collection periods should contemplate tightening credit policies to expedite payment collections and fortify financial stability.
What is a Good Average Collection Period?
When evaluating your company’s average collection period, the benchmark to aim for is 60 days or less. An average collection period of 60 days or under is generally considered favorable. It signifies that your business is efficiently converting sales to cash within a two month timeframe. A shorter collection period translates to greater liquidity, and reduced risk, and indicates you likely have effective credit, billing, and collection processes in place. Extending into the 61 to 90-day range could signal potential problems with collections and cash flow. Anything over 90 days average collection time is a red flag, and serious action needs to be taken to improve collections. Bringing your average collection period down as close to 30 days as your industry will allow is ideal. Overall, strive for an average collection period of 60 days or less as a sign of a healthy mix of sales growth and diligent collection practices.
Example Calculation
Here are example calculations of the average collection period with analysis:
High Example
A consulting firm has an average accounts receivable balance of $20,000 and total net sales of $100,000 for the year.
Calculation: ($20,000 / $100,000) x 365 = 73 days
This is a high average collection period, indicating potential issues with collections or lenient credit terms. Action may be needed to reduce the collection time.
Average Example
A retail company has an average accounts receivable balance of $50,000 with total net sales of $500,000.
Calculation: ($50,000 / $500,000) x 365 = 36.5 days
This is an average collection period, typical for the retail industry. It signifies efficient credit and collection practices are in place.
Low Example
A software company has an average accounts receivable of $10,000 and total net sales of $200,000.
Calculation: ($10,000 / $200,000) x 365 = 18.25 days
This is a low average collection period, indicative of strong accounts receivable management. The company is rapidly converting sales to cash.
Interpreting the Results
Here is an interpretation of the results from the three average collection period examples:
For the consulting firm with a 73 day average collection period, this result indicates potential issues with collections or lenient credit terms. A period higher than 60 days points to delays in converting sales to cash, which could strain cash flow. Action may be needed to reduce the collection time through stricter credit policies or improved collection procedures.
The retail company’s 36.5 day average collection period is typical for that industry. It signifies that efficient credit issuance and collection practices are likely in place. Maintaining an average of under 60 days demonstrates the company is effectively managing its accounts receivable.
With an 18.25 day average collection period, the software company is collecting outstanding receivables rapidly. This low period highlights very strong accounts receivable management practices are implemented. Quickly converting sales to cash improves liquidity and reduces financial risk.
Comparing the examples shows how average collection periods vary across industries.
Practical Applications and Usefulness
Here are some ways the average collection period can provide practical applications and usefulness for businesses:
- Enables better cash flow forecasting and liquidity management – Knowing typical collection cycles allows more accurate predictions of cash inflows for meeting obligations.
- Guides the setting of credit terms and policies – Companies can set credit limits and payment terms optimized to their collection abilities.
- Identifies issues with collections or revenue cycles – Spiking collection periods could indicate problems to address proactively.
- Assesses the effectiveness of AR management practices – Continuous monitoring shows if process improvements are working.
- Determines the level of bad debt provisions needed – Longer collection periods may require larger allowances for doubtful accounts.
- Provides insight into customer payment behavior – Variations can inform changes to invoicing and collections.
- Supports data-driven decision making – Trend analysis helps guide smart choices on credit, billing, and staffing.
- Allows comparison to industry benchmarks – Context helps determine if collection periods are competitive.
- Helps achieve working capital and cash flow targets – Optimizing the metric aligns with strategic financial goals.
Wrapping Up
Managing your average collection period provides significant insights into the effectiveness of your company’s credit policies, billing procedures, and accounts receivable practices. Monitoring this metric on an ongoing basis, benchmarking against peers, and analyzing trends over time enables data-driven decisions to optimize cash flow.
Whether your goal is to improve liquidity, reduce risk, or boost working capital, bringing your average collection period in line with industry standards is key. With the simple steps outlined here for calculating average days sales outstanding, you now have an essential tool for assessing financial health, guiding profitable growth, and achieving your strategic business objectives.
Neil Duncan, a professional in business innovation and management, has a deep interest in writing and sharing his voice by publishing articles on different b2b and b2c websites/blogs like this. He currently serves as the Vice President in AZ.
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