What is an Average Collection Period?
Definition: The average collection period is the average number of days required to collect invoiced amounts from customers. The measure is used to determine the effectiveness of a company’s credit granting policies and collection efforts.
What Does Average Collection Period Mean?
The average collection period is the average number of days between
- the dates that credit sales were made, and
- the dates that the money was received/collected from the customers.
The average collection period is also referred to as the days’ sales in accounts receivable.
Companies calculate the average collection period to make sure they have enough cash on hand to meet their financial obligations.
The formula for the average collection period (ACP) is:
ACP = Average accounts receivable ÷ (Annual sales ÷ 365 days)
Company ABC is a retail company that operates in the home appliance industry. The company has a tight credit policy because it plans to pay off its short debt by the end of the fiscal year. Anna, the company’s accountant, wants to calculate the average period and determine if there should be any adjustments in the company’s credit policies.
The company’s accounts receivable is $10,185 for the last quarter. For this amount, Anna calculates that the credit sales are $105,452. Therefore:
ACP = $10,185 ÷ ($105,452 ÷ 365) = 35.2 days
This means that customers pay their credit to the company every 35 days on average.
Anna calculates the average collection for the same quarter last year as a basis for comparison. Therefore:
ACP = $13,254 / $110,986 x 365 = 43.6 days
The collection period has dropped by 8 days YoY, and it has improved. However, it remains high. The company needs to adjust its credit policies to lower the collection period down to a week and be able to meet its short-term obligations.
Understanding the Average Collection Period
Average collection periods are most important for companies that rely heavily on receivables for their cash flows.
An increase in the average collection period can be indicative of any of the following conditions:
- Looser credit policy. Management has decided to grant more credit to customers, perhaps in an effort to increase sales. This may also mean that certain customers are being allowed a longer period of time before they must pay for outstanding invoices. 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. General economic conditions could be impacting customer cash flows, requiring them to delay payments to their suppliers.
- Reduced collection efforts. There may be a decline in the funding for the collections department or an increase in the staff turnover of this department. In either case, less attention is paid to collections, resulting in an increase in the amount of receivables outstanding.
A decrease in the average collection period can be indicative of any of the following conditions:
- Tighter credit policy. Management may restrict the granting of credit to customers for a number of 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. The company may have imposed shorter payment terms on its customers.
- Increased collection efforts. Management may have decided to increase the staffing and technology support of the collections department, which should result in a reduction in the amount of overdue accounts receivable.
The measure is best examined on a trend line, to see if there are any long-term changes. In a business where sales are steady and the customer mix is unchanging, the average collection period should be quite consistent from period to period. Conversely, when sales and/or the mix of customers is changing dramatically, this measure can be expected to vary substantially.
Average Collection Period Analysis
The average collection period is a great analytical tool to measure the efficiency of a company that allows credit lines as a method of payment.
One example of the need for this formula is in banking. Since bank services are focused almost completely on lending and receiving money from their customers, it is extremely important for them to have a consistent collection period for their financial security.
Additionally, since construction companies are typically paid per project (without a steady revenue stream), they also depend on this calculation. Since payments on these projects can fund other projects, they need to make sure clients are paying on time and in the correct amounts.
Property management and real estate companies would also need to be constantly aware of their average collection period. In property management, almost their entire cash flow is done on credit and dependant on tenants paying their rent monthly. If they are not able to successfully collect from their residents, it can affect the cash flow they have to purchase maintenance supplies, cover operating costs, or pay employees.
Accounts Receivable Turnover
The average collection period is closely related to the accounts receivable turnover ratio. The accounts turnover ratio is calculated by dividing total net sales by the average accounts receivable balance.
In the previous example, the accounts receivable turnover is 10 ($100,000 ÷ $10,000). The average collection period can be calculated using the accounts receivable turnover by dividing the number of days in the period by the metric. In this example, the average collection period is the same as before at 36.5 days (365 days ÷ 10).
Significance and Use of Average Collection Period Formula
To get a more valuable insight into the business we must know the company’s Average Collection period ratio. But get a meaningful insight we can use the Average Collection period ratio as compared to other companies’ ratio in the same industry or can be used to analyze the trend of the previous year. This ratio shows the ability of the company to collect its receivables and also the average period is going up or down. The company can make changes in the collection policy to handle the liquidity of the business.
We can also compare the company’s credit policy with the competitors on the average days taken by the company from credit sale to the collection and can judge how well a company is doing.
If the company have an average collection period of 40 days, but the company has a credit policy to collect the receivables in 30 days, then there is a problem in the collection team of the company. In case the average collection period is 40 days and the company has announced a credit policy of 15 days, then this situation is significantly worse. The customers are not following the credit agreement terms, and this needs a look at your company’s credit policy and introducing measures to change the current scenario. Following measures can be taken for making the current scenario abiding:
- Require Tightening of credit.
- Instructing the customers on the credit terms.
- Offering Discount to the customers in case they are paying the credit in advance, offering 2 % discount in case customer paid in first ten days.
- Follow-Up with the credit team on delinquent accounts.
- Charging interest on delay on paying the account receivables.
- The average collection period is the amount of time it takes for a business to receive payments owed by its clients.
- Companies calculate the average collection period to ensure they have enough cash on hand to meet their financial obligations.
- Low average collection periods indicates organizations collect payments faster.