Average Collection Period Formula, How It Works, Example

average collection period definition

Not all metrics work for all businesses, so having an abundance of performance indicators is more valuable than relying on a single number. When customers take their steps to make payments, waiting for processing time to end is not good for both. Monitoring your financial health is important to maintain a positive cash flow and sustain growth.

  • This metric should exclude cash sales (as those are not made on credit and therefore do not have a collection period).
  • The formula below is also used referred to as the days sales receivable ratio.
  • The average collection period is the average number of days it takes for a credit sale to be collected.

The average collection period must be monitored to ensure a company has enough cash available to take care of its near-term financial responsibilities. It can set stricter credit terms limiting the number of days an invoice is allowed to be outstanding. This may also include limiting the number of clients it offers credit to in an effort to increase cash sales. It can also offer pricing discounts for earlier payment (i.e. 2% discount if paid in 10 days). In order to calculate the average collection period, divide the average balance of accounts receivable by the total net credit sales for the period.

Analyze and optimize cash flow

The average collection period is an accounting metric used to represent the average number of days between a credit sale date and the date when the purchaser remits payment. A company’s average collection period is indicative of the effectiveness of its AR management practices. Businesses must be able to manage their average collection period to operate smoothly. Accounts receivable is a business term used to describe money that entities owe to a company when they purchase goods and/or services. AR is listed on corporations’ balance sheets as current assets and measures their liquidity. As such, they indicate their ability to pay off their short-term debts without the need to rely on additional cash flows.

average collection period definition

Or alternatively, you can penalize late payers with a significant late charge. When you are selling products on a credit basis, you should weigh if the buyers are eligible to repay on time. For better client management, looking deeper into clients’ creditworthiness is important. The average collection period does not hold much value as a stand-alone figure.

What Is a Good Average Collection Period Ratio?

It’s vital that your accounts receivable team closely monitor this metric and keep it as low as possible. We’ll discuss how to analyze average collection period further in this article. Average collection period is the number of days it takes to receive payment for goods or services. 15 to 30 days should be the average collection period for accounts receivable. You can receive payments quickly and send reminders without putting any effort. Let your accounts receivable team put more effort into accepting payments on time.

average collection period definition

You must first calculate the accounts receivable turnover, which tells you how many times customers pay their account within a year. The average collection period indicates the effectiveness of a firm’s accounts receivable management practices. It is very important for companies that heavily rely on their receivables when it comes to their cash flows. Businesses must manage their average collection period if they want to have enough cash on hand to fulfill their financial obligations.

Average Collection Period: Formula 1

The average collection period is a measurement of the average number of days that it takes a business to collect payments from sales that were made on credit. Businesses of many kinds allow customers to take possession of merchandise right away and then pay later, typically within 30 days. These types of payments are considered accounts receivable because a business is waiting to receive these payments on an account. The average collection period amount of time that passes before a company collects its accounts receivable (AR). In other words, it refers to the time it takes, on average, for the company to receive payments it is owed from clients or customers.

  • General economic conditions could be impacting customer cash flows, requiring them to delay payments to their suppliers.
  • When you are selling products on a credit basis, you should weigh if the buyers are eligible to repay on time.
  • This issue is a major one, since the problem arises entirely outside of the business, giving management no control over it.
  • This often means turning to debt collectors, repossession, or other expensive alternatives to recover the expected funds.

If you discover shockingly high values when you calculate average collection period, you must work on ways to reduce them. Here are the ways to shorten the collection period without losing customers. Unless you run a finance-based business, accessing their financial statements is not possible for you. Yet, with the calculation of average collection period, you can predict and understand their creditworthiness. Finance professionals weigh multiple factors to determine the average performance of their company. One of the important factors that highlight turnover and cash flow management is the average collection period.

Importance of calculating average collection period

To calculate your total net credit sales, take your total sales made on credit for a given period and subtract any returns and sales allowances. The time they require to collect the money back from the customer is known as the accounts receivable collection period. To explain this better, let’s take a look at the hypothetical case of a company, ‘XYZ’. But they only managed to collect $ 10,000, which is their accounts receivable balance. Before starting this, the accounts receivable team should estimate the total collection made for the year and the total net sale amount (the amount they might have made with sales throughout the year).

This is not a bad figure, considering most companies collect within 30 days. Collecting its receivables in a relatively short and reasonable period of time gives the company time to pay off its obligations. The best way that a company can benefit is by consistently calculating its average collection period and using it over time to search for trends within its own business. The average collection period may also be used to compare one company with its competitors, either individually or grouped together. Similar companies should produce similar financial metrics, so the average collection period can be used as a benchmark against another company’s performance. With Versapay, your customers can make payments at their convenience through an online self-service portal.

This is great for customers who want their purchases right away, but what happens if they don’t pay their bills on time? The accounting manager at Jenny Jacks is going to be watching for this and will run monthly reports to assess whether payments are being made on time. He’s going to calculate the average collection period and find out how many days it is taking to collect payments from customers. The average collection period can be found by dividing the average accounts receivables by the sales revenue. Companies create their credit policies based on when they need payments from their customers.