Definition of the average collection period


What is the average collection period?

The average collection period is the amount of time it takes for a business to receive payments owed by its customers in terms of accounts receivable (AR). Businesses use the average collection period to ensure they have enough cash on hand to meet their financial obligations.

The average collection period is indicative of the effectiveness of a company’s AR management practices. It is most important for businesses that rely heavily on accounts receivable for their cash flows.

Key takeaways

  • The average collection period is the amount of time it takes for a business to receive payments owed by its customers.
  • Companies calculate the average collection period to ensure they have enough cash on hand to meet their financial obligations.
  • A low average collection period indicates that an organization collects payments faster.

Understanding the average collection period

The average collection period represents the average number of days between the date a sale on credit is made and the date the buyer pays for that sale. The average collection period of a company is indicative of the effectiveness of its AR management practices. Businesses must be able to manage their average collection period in order to operate smoothly.

A lower average collection period is generally more favorable than a higher average collection period. A low average collection period indicates that the organization collects payments faster. However, this has a disadvantage, as it can mean that the credit terms are too strict. Customers can choose to search for vendors or service providers with more lenient payment terms.

The average AR balance is calculated by adding the beginning balance in AR and the ending balance in AR and dividing that total by two. When calculating the average collection period for a full year, 365 can be used as the number of days in a year for simplicity.

Average collection period

How to calculate the average collection period

The average collection period is calculated by dividing the average AR balance by the total net credit sales for the period and multiplying the quotient by the number of days in the period. Let’s say a business has an average AR balance for the year of $ 10,000. Total net sales recorded by the company during this period were $ 100,000. We would use the following average collection period formula to calculate the period:

($10,000 ÷ $100,000) x 365 = Average Collection Period

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The average collection period, therefore, would be 36.5 days; not a bad number, considering that most companies charge within 30 days. The collection of your accounts receivable in a relatively short and reasonable period of time gives the company time to pay its obligations.

If the average collection period for this company were longer, say more than 60 days, you would need to adopt a more aggressive collection policy to shorten that period of time.

Turnover of accounts receivable (AR)

The average collection period is closely related to the account turnover ratio, which is calculated by dividing the total net sales by the average AR balance. In the example above, the AR turnover is 10 ($ 100,000 ÷ $ 10,000). The average collection period can also be calculated by dividing the number of days in the period by the AR sales volume. In this example, the average collection period is the same as before: 36.5 days.

365 days ÷ 10 = Average Collection Period

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Comparability

The average collection period does not have much value as a stand-alone figure. Instead, you can get more out of its value by using it as a comparison tool.

The best way a business can benefit is by constantly calculating its average collection period and using it over time to look for trends within its own business. The average collection period can also be used to compare a company with its competitors, either individually or in groups. Similar companies should produce similar financial metrics so that the average collection period can be used as a benchmark against the performance of another company.

Companies can also compare the average collection period with the credit terms granted to customers. For example, an average collection period of 25 days is not as worrisome if invoices are issued with a net due date of 30. However, an ongoing evaluation of the outstanding collection period directly affects the organization’s cash flows.

Collections by industries

Not all companies treat credit and cash in the same way. Although available cash is important to all businesses, some are more reliant on their cash flow than others.

For example, the banking industry relies heavily on accounts receivable due to the loans and mortgages it offers to consumers. As it depends on the revenue generated by these products, banks must have a short response time for accounts receivable. If they implement lax collection policies and procedures, revenue would be reduced and financial damage would be done.

Real estate and construction companies also rely on constant cash flows to pay for labor, services, and supplies. These industries do not necessarily generate income as easily as banks, so it is important that those who work in these industries bill at appropriate intervals, as sales and construction take time and may be subject to delays.

Frequent questions

Why is the average collection period important?

The average collection period is indicative of the effectiveness of a company’s accounts receivable management practices and is most important for companies that rely heavily on accounts receivable for their cash flows. Businesses need to be able to manage their average collection period to ensure they have enough cash on hand to meet their financial obligations.

How is the average collection period calculated?

The average collection period is calculated by dividing the average balance of accounts receivable by the total net credit sales for the period and multiplying the quotient by the number of days in the period. Therefore, if a business has an average accounts receivable balance for the year of $ 10,000 and total net sales of $ 100,000, then the average collection period would be (($ 10,000 ÷ $ 100,000) x 365), or 36.5 days.

Why is a lower average harvest period better?

A lower average collection period is generally more favorable than a higher average collection period, as it indicates that the organization is more efficient in collecting payments. However, this has a downside, as it may indicate that your credit terms are too tight, which could lead to the loss of customers to competitors with more lenient payment terms.

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Mark Holland

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