Average collection period

From CEOpedia | Management online

Average collection period is how fast on average a company receives accounts receivable. The measure is used to determine the effectiveness of a company's credit granting policies and collection efforts. In other words, this financial ratio is the average number of days required to convert receivables into cash. The mathematical formula to determine average collection ratio is simple but requires collecting some financial information first. The calculation of average collection period is calculated as follows:

ACP = average balance of accounts receivable / total net credit sales in period x number of days in period

When using this average collection period ratio formula, the number of days can be a year (365) or a nominal accounting year (360) or any other period, so long as the other data - average accounts receivable and net credit sales - span the same number of days.

The result is shown in days, e.g. 30 days. The shorter the period is the better. It should be compared with average settling liabilities period. If our customers pay quicker than we pay to our suppliers whe can earn on that difference (e.g. overnights). If we pay faster then our customers - we need larger operating loan, which costs us money.

One calculation has limited value. It is better to collect data over longer period and analyze it to detect growing problems with collecting payments.

Example

"Company has average accounts receivable of $1,000,000 and annual sales of $6,000,000. The calculation of its average collection period is: $1,000,000 Average receivables ÷ ($6,000,000 Sales÷365 days)= 60.8 Average days to collect receivables"(Bragg S., 2018, p. 1)

An increase in the average collection period

Growth in the average collection period can be disclose of any of the following conditions:

  • Looser credit policy. This may mean that someone customers are being allowed a longer period of time before they will be able to settle the rest of the plumbers later. This is especially common when a small business wants to sell to a large retail chain, which can promise a large sales boost in exchange for long payment terms.
  • Worsening economy. Delay in payments can also be horses economic situation in the country.
  • Reduced collection efforts. There may be an growth in the staff turnover of this department or a decline in the funding for the collections department. In either case, less attention is paid to collections, resulting in an increase in unpaid receivables (Bragg S., 2018, p. 1).

A decrease in the average collection period

A reduction in the average collection period can be disclose of any of the following conditions:

  • Tighter credit policy. Management may limit lending for many reasons, such as in anticipation of a decline in economic conditions or not having enough working capital to support the current level of accounts receivable.
  • Reduced terms. You can impose shorter payment terms on clients.
  • Increased collection efforts. Management may have decided to infrease the staffing and technology support of the collections department, which should result in a reduction in the amount of overdue accounts receivable (Bragg S.2018, p. 1).

Advantages of Average collection period

The average collection period is an important measure of a company's credit management and collection efforts. It gives an indication of how long it takes for customers to pay back their accounts receivable. Here are some of the advantages of measuring this ratio:

  • It enables businesses to identify any potential issues with their receivables and take action to resolve them.
  • It measures the average time it takes for a company to collect money from customers and, as such, assesses the efficiency of the credit and collection process.
  • It helps businesses to identify any customers who are not paying their debts on time, so they can take appropriate action.
  • It helps companies to keep track of their working capital and cash flow.
  • It provides a benchmark for the company to compare their performance with that of their competitors.

Limitations of Average collection period

The average collection period is a useful tool for understanding how quickly a company is able to collect its receivables, but it has some limitations. The main limitations of the average collection period are as follows:

  • It does not provide any information on the quality of the receivables or the risk associated with them.
  • It is a lagging indicator, so it does not provide any information on current payment trends or customer behavior.
  • It does not take into account the effect of discounts or different payment terms offered by customers.
  • It does not take into account the impact of write-offs or bad debt.
  • It does not consider the potential for future sales growth or changing customer payment habits.

Other approaches related to Average collection period

One approach to measuring a company's average collection period is to analyze the following items:

  • Accounts receivable turnover: This is the ratio of net credit sales to average accounts receivable. A high turnover ratio indicates that customers are paying their bills promptly, while a low ratio indicates that customers are taking longer to pay their bills.
  • Days sales outstanding (DSO): This is the average number of days that it takes customers to pay their invoices after they have been sent out. A higher DSO ratio indicates that customers are taking longer to pay, which can put strain on the company's cash flow.
  • Average payment period: This is the average number of days that the company takes to pay its suppliers. A high average payment period could indicate that the company is taking advantage of its suppliers and delaying payment.

In summary, the average collection period is a measure of how quickly a company is able to receive its accounts receivable, and it can be measured using a variety of methods such as accounts receivable turnover, days sales outstanding, and average payment period. This ratio helps companies evaluate their credit granting policies and collection efforts.


Average collection period — recommended articles
Payables turnover — Days payable — Defensive interval ratio — Burn Rate — Capital gearing — Activity ratios — Average payment period — Debt management ratio — Cash Flow-to-Debt Ratio

References

Author: Angelika Bogdanik

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