The average collection period is the time it takes for a company’s clients to pay back what they owe. In other words, it is the average number of days it takes your business to turn accounts receivable into cash.
Similar to days sales outstanding, a business’ average collection period can tell the owner the liquidity of his or her company’s accounts receivable, or how readily that money can be converted to cash. This, in turn, allows the business owner can evaluate how well their credit policy is working and gives them a better handle on their cash flow.
Average Collection Period Formula
Average collection periods are calculated by dividing the average accounts receivable amount for a period by the net credit sales for the period and multiplying by the number of days in the period. The result of this formula shows how long it takes on average to collect payments from sales that were made on credit.
Average Collection Period = (Average Accounts Receivable / Net Credit Sales) x Days in Period
- The days in the period can be any number of days. However, since you need to calculate the average accounts receivable within that period, companies will often look at the last year (or 365 days) for simplicity’s sake.
- You can find your average accounts receivable by adding accounts receivables totals from the beginning and end of the period then dividing by two. If you have financial statements available from each month or quarter of the period, you may also average the amounts found on your past balance sheets for a more accurate number.
- Net credit sales is the total of all sales made on credit less all returns for the period.
Let’s say a consulting firm finds that it has an average of $10,000 in accounts receivable and made $160,000 in credit sales last year. To find their average collection period, they would do the following:
($10,000 / $160,000) x 365 days = 22.8 days
As you can see, the average collection period for this firm is 22.8. This means it takes the company a little over three weeks to collect payments on their outstanding invoices—a great number for many companies.
What Does the Average Collection Period Say About Your Business?
Every company will have its own standards for its average collection period, depending largely on its credit terms. If the firm above, with an average collection period of 22.8 days, has 30-day terms, they’re in great shape. If they have 14-day terms, that means few customers are actually paying on time. Whether your average collection period is “good” or “bad” will depend on how close it is to your credit terms—though lower is generally better.
Because of this, the key to measuring your average collection period is to do it regularly. If you notice your average collection period jump from 22.8 days to 32.8 days, that could have big effects on your cash flow and you’ll want to take steps to keep that upward trend from continuing.
A lower average collection period indicates the company is collecting payments faster, which sounds great in theory, but there is a downside in collecting payments too fast. If customers think your credit terms are too strict, they could seek other providers with more flexible payment options. Your company has to find the average collection period and credit policies that work best for your business’s needs, but that also won’t deter your customers from doing business with you.
Constantly calculating your average collection period can seem like a tedious task, but you don’t have to do it yourself. An accounting automation software like ScaleFactor can give you all of the reports and insights you need.
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