Average collection period
| Average collection period |
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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:
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, s.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, s.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, s.1).
References
- Bragg, Steven (January 31, 2018) Average collection period Accounting Tools, 1, 1.
- Mathuva, David, M.(2015) The Influence of working capital management components on corporate profitability Journal of Business Management, 4(1), 1-11.
- Nasr, Mohamed, Raheman, Abdul (March, 2007) Working Capital Management And Profitability – Case Of Pakistani Firms International Review of Business Research Papers, Vol. 3 No. 1, 279-300.
- Peavler, Rosemary (May 3, 2018) What Is the Average Collection Period Ratio? The balance small biznes, 1, 1.
Author: Angelika Bogdanik
