The average collection period is the average period of time it takes for a firm to collect its accounts receivable. Business owners and managers must closely monitor the metric to ensure that the company has enough cash available to cover its short-term financial obligations. In this article, we are going to take a look at how to calculate and analyze the average collection period.
Highlights/ Key Takeaways
- The average collection period is the amount of time a business spends collecting its accounts receivables (AR). This value provides insights into how effectively the business manages its AR.
- The average collection period can be calculated by dividing the average AR amount by the total net credit sales and multiplying the result by the number of days in the period.
- Keeping track of the average collection period allows companies to ensure that they have sufficient cash to meet their financial responsibilities.
- In general, the lower the average collection period, the better. Lower values mean that a company collects payments faster.
What Is the Average Collection Period?
The term average collection period, or ACP, describes the amount of time taken by an organization to convert its accounts receivables to cash. Also known as days sales outstanding, or DSO, the average collection period is an important metric that helps businesses evaluate whether they will have enough cash on hand to meet their short-term financial obligations.
Typically, lower collection periods are preferred, as the shorter duration indicates more efficiency in credit collections. On the other hand, a high average collection period signals that a company might be taking too long to collect payments on their accounts receivables.
How Does the Average Collection Period Work?
Companies often make sales to their customers or other entities on credit. The money that these entities owe to a business when they purchase products or services is recorded on a company’s balance sheet, under accounts receivable or AR. The AR value measures a company’s liquidity, as it indicates its ability to cover short-term debts without relying on additional cash flows.
The average collection period is a metric used in accounting to represent the average number of days it takes a company to collect payment after a credit sale. The value of a company’s ACP is used to evaluate the effectiveness of its AR management practices. In addition, properly managing the ACP and keeping it low is necessary for any company to operate smoothly.
“The average collection period is a metric used in accounting to represent the average number of days it takes a company to collect payment after a credit sale.”
Why Is the Average Collection Period Important?
Companies calculate and manage the average collection period for three main reasons: to maintain liquidity, to effectively plan for future costs, and to analyze their current credit terms.
1. Maintaining Liquidity
Companies strive to receive payments for goods and services they provide in a timely manner. Quick payments enable the organization to maintain the necessary level of liquidity to cover its own immediate expenses.
Calculating the average collection period and keeping it relatively low allows businesses to maintain liquidity. It also provides the management with a general idea of when they might be able to make larger purchases.
2. Predicting Cash Flow and Planning for Future Costs
From a timing perspective, looking at the average collection period can help a company to schedule potential expenditures and prepare a reasonable plan for covering these costs.
For example, suppose a company has an average collection period of 25 days, and they have $100,000 in AR, which is 20 days old. In that case, the company can likely expect the payment within one week.
Analyzing Credit Terms
Naturally, a smaller value of the average collection period ratio is considered more beneficial for a company. It indicates that a company’s clients pay their bills faster, or that the company collects payments faster.
On the other hand, a fast collection period can simply mean that a company has established strict credit terms. While such terms may work for some clients, they may turn others away, sending them in search of competitors with more lenient payment rules.
Calculating the Average Collection Period
To find the average collection period of a company, you need to obtain its accounts receivable values from the balance sheet, along with its revenue for the same period. Ideally, you should use the company’s credit sales, but such specific information is not always available.
Average Collection Period Formula
The formula used for calculating the ACP value is:
Average Collection Period = (Accounts Receivable / Net Credit Sales ) x 365 days
To find the ACP value, you would need to divide a company’s AR by its net credit sales and multiply the result by the number of days in a year.
Here, net credit sales come from the income statement, which covers a period of time. At the same time, the AR value can be found on the balance sheet, which provides a snapshot of a point in time. As such, it is acceptable to use the average balance of AR over the same period of time as covered in the income statement.
Alternatively, you could express the ACP as the number of days in a year divided by the receivables turnover of a company:
Average Collection Period = 365 days / Receivables Turnover,
where Receivables Turnover = Net Credit Sales / Accounts Receivable
The receivables turnover value is the number of times that a company collects payments from customers per year. It can be found by dividing a company’s credit sales by the average AR value.
“Net credit sales come from the income statement, which covers a period of time. At the same time, the AR value can be found on the balance sheet, which provides a snapshot of a point in time. As such, it is acceptable to use the average balance of AR.”
How Is the Average Collection Period Calculated?
To calculate your company’s average collection period, you would need to follow four simple steps:
Step 1: Calculate Average Accounts Receivable
Average accounts receivable can be calculated by averaging the values of starting and ending accounts receivable:
Average Accounts Receivable = (Starting AR + Ending AR) / 2
From here on out, we are going to refer to this average value simply as “accounts receivable.”
Step 2: Calculate Net Credit Sales
To calculate the value of net credit sales, you would need to subtract returns and sales allowances from total sales made on credit:
Net Credit Sales = Sales on Credit - Returns and Sales Allowances
Step 3: Calculate Accounts Receivable Turnover Ratio
Next, you will need to divide the total net credit sales by the accounts receivable value for a given period:
Receivables Turnover = Net Credit Sales / Accounts Receivable
Step 4: Calculate the Average Collection Period
Finally, to find the value of the average collection period, you will need to divide the average AR value by total net credit sales and multiply the result by the number of days in a year. Most of the time, the number of days in a year is taken to be 365 or 360 days.
Average Collection Period = (Accounts Receivable / Net Credit Sales) x 365 days
Alternatively, you can divide the number of days in a year by the receivables turnover ratio calculated previously.
Average Collection Period = 365 days / Receivables Turnover
Example of an Average Collection Period Calculation
Let us take a look at a numerical example of calculating the average collection period.
Suppose Company ABC has the following inputs:
- Starting receivables: $400,000
- Ending receivables: $200,000
- Sales on credit: $4,000,000
- Returns and sales allowances: $2,000,000
- Period analyzed: 365 days
The average collection period can then be calculated as follows:
Accounts Receivable = (Starting AR + Ending AR) / 2 =
= ($400,000 + $200,000) / 2 = $300,000
Net Credit Sales = Sales on Credit - Returns and Sales Allowances =
= $4,000,000 - $2,000,000 = $2,000,000
Receivables Turnover = Net Credit Sales / Accounts Receivable =
= $2,000,000 / $300,000 = 6.67
Average Collection Period = 365 days / Receivables Turnover =
= 54.72 days
If Company ABC aims to collect money owed within 60 days, then the ACP value of 54.72 days would indicate efficiency. However, if their target collection period is 30 days, the ACP value of 54.72 days would be too high, indicating inefficiency in the company’s collection efforts.
Analyzing Average Collection Period
The average collection period calculation is often used internally for analyzing the company’s liquidity and the efficiency of its accounts receivable collections.
How Do Businesses Use the Average Collection Period Calculation?
An average collection period is a single number that can provide loads of useful information to business management. Some common ways in which businesses use the ACP value are:
- To evaluate how efficiently debts are collected. A sale cannot be fully completed until the company receives the full payment. Calculating the ACP value provides insights into the efficiency of a company’s debt collections.
- To assess a company’s short-term financial health. Without timely cash collections, a company will lack liquidity and will likely go insolvent due to its inability to pay short-term bills.
- To evaluate the performance of competitors. Public companies must share all the figures required to calculate the average collection period. Calculating ACP for competitor companies can provide insights into the way they operate.
- To gauge how strict credit terms are. Loose credit terms may attract customers looking to take advantage of lenient payment rules. At the same time, credit terms that are too strict may drive customers away.
- To catch early signals of bad allowances. As the ACP value increases, more clients are taking longer to pay. This may signal the risk that the outstanding receivables may remain uncollected and require closer monitoring and communication with clients.
What Is a Good Average Collection Period?
Generally speaking, an average collection period under 45 days is considered good. However, the number can vary by industry and will depend on the exact deadlines of invoices issued by a company.
For example, if a company has an ACP of 50 days but issues invoices with a 60-day due date, then the ACP is reasonable. On the other hand, if the same company issues invoices with a 30-day due date, an ACP of 50 days would be considered very high.
“Generally speaking, an average collection period under 45 days is considered good. However, the number can vary by industry and will depend on the exact deadlines of invoices issued by a company.”
Why Is a Lower Average Collection Period Better?
A lower average collection period usually means that a company has efficient collection practices, tight credit policies, or shorter payment terms.
Companies strive to lower their average collection periods, but remember to not overdo it: credit policies that are too strict or payment terms that are too short may drive away potential customers in search of more lenient options.
What Does a Decreasing Average Collection Period Indicate?
A decreasing average collection period is generally the trend companies like to see. Most of the time, this signals that the management has prioritized investment in collections and improved the collections processes.
The ACP value could also decrease if a company has imposed shorter payment deadlines and tightened its credit policies.
What Does a Rising Average Collection Period Indicate?
If your company’s ACP value continues to increase over time, it may indicate that your credit policies are too loose or payments are not collected efficiently. Sometimes, the rising trend may even signal the general worsening of the economy.
Keep in mind that slower collection times could result from poor customer payment experiences, such as manual data entry errors or slow billing payment processes.
How Companies Can Improve Their Average Collection Period
The main way to improve the average collection period without imposing overly strict credit policies or short invoice deadlines is to make the collection processes more efficient. This can be done by automating everything from communication and customer management to invoicing and collections.
Here are a few ways in which companies can improve their ACP values:
- Careful customer management and reporting. Keeping track of the current status of all accounts receivable and reviewing the data is the first step in addressing the average collection period.
- Automated invoicing. With the dedicated software, you can generate and send out invoices automatically, ensuring that customers receive them as quickly as possible.
- No-touch collections. You can also deliver automated reminders to customers before and after the invoice due date. This can prompt the customers to pay their bills faster.
- Better customer experiences. Simplifying the payment process and improving the overall customer experience can make things easier for the customers, empowering them to pay quickly and efficiently.
Final Word
There are many reasons a business owner may want to understand the average collection period meaning, calculation, and analysis. Not only does the ACP value provide important insights into the company’s short-term liquidity and the efficiency of its collection processes, but it can even be used to catch early signs of bad allowances. Most importantly, the ACP is not difficult to calculate, with all the necessary information readily available on a company’s balance sheet and income statement.
