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Average Collection Period: Formula – Definition – Example

What Is the Average Collection Period?

Average Collection PeriodThe average collection period (ACP) is the amount of time it takes for a business to receive outstanding payments.  These are payments owed by its clients for goods or services in terms of accounts receivable (AR). Companies calculate the average collection period to make sure they have enough cash on hand to meet their financial obligations. The average collection period is calculated by dividing the average balance of accounts receivable by total net credit sales for the period and multiplying the quotient by the number of days in the period.  Collection periods are most important for companies that rely heavily on receivables for their cash flows.

Definition – 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 or collected from the customers. The average collection period is also referred to as the days’ sales in accounts receivable.

The average collection period is the amount of time it takes for a business to receive payments owed by its clients.  Companies calculate the ACP to ensure they have enough cash on hand to meet their financial obligations. Low average collection periods indicate organizations that collect payments efficiently.

Average Collection Period Explained

The Average Collection Period (ACP) represents the average number of days between the date a credit sale is made and the date the purchaser pays for that sale. A company’s average collection period indicates how effective a company’s accounts receivable management practices are. Businesses must be able to manage their average collection period in order to ensure they can pay bills ad service debt.

A lower average collection period is preferred to a higher average collection period. A low average collection period indicates the organization collects payments faster. The downside, though, is that it may indicate its credit terms are too strict. Customers may seek suppliers or service providers with more lenient payment terms.  The average balance of accounts receivable is calculated by adding the opening balance in accounts receivable (AR) and ending balance in accounts receivable and dividing that total by two. When calculating the average collection period for an entire year, 365 may be used as the number of days in one year for simplicity.

Average Collection Period Formula #1

One formula for calculating the average collection period –  365 days in a year divided by the accounts receivable turnover ratio.

Average Collection Period = 365 Days / AR Turnover Ratio

Example using Formula #1

Assume that a company had on average $40,000 of accounts receivable during the most recent year. During that year the company had credit sales of $400,000.

  • The accounts receivable turnover ratio is $400,0000 divided by $40,000 = 10 times per year.
  • The average collection period = 365 days divided by the turnover ratio of 10 = 36.5 days.

Average Collection Period Formula #2

An alternate formula for calculating the average collection period is the average accounts receivable balance divided by the average credit sales per day.

Average Collection Period = Average AR Balance / Average Credit Sales per Day

Example using formula #2

Use the same assumptions from above: A company had on average $40,000 of accounts receivable during the most recent year. During that year the company had credit sales of $400,000.

  • Average credit sales per day is $400,000 of credit sales divided by 365 days = $1,096.
  • The average accounts receivable balance is $40,000
  • The average collection period = $40,000 / $1,096 = 36.5 days

Average Collection Period Uses

The average collection period does not hold much value as a standalone figure. Instead, you can get more information and value by using it as a comparative tool.

Internal Historical Trends

The best way a company can benefit is by consistently calculating its ACP.  Then, use this figure historically to search for trends within its own business. The average collection period may also be used to compare one company with its competitors.  This can be either individually or grouped together. Similar companies should produce similar financial metrics.  So. the average collection period can be used as a benchmark against other companies performances.

Extended Credit Terms

Companies may also compare the ACP to the credit terms they extend to customers. For example, an average collection period of 25 days is good performance if invoices are issued with a net 30 due date. However, if the average collection period is 45 days, but the firm’s credit policy is to collect its receivables in 30 days, that’s a problem. An ongoing evaluation of the outstanding collection period directly affects the organization’s cash flows.

Importance of the Average Collection Period

Maintain liquidity

Clearly, every company needs to receive payment for goods or services rendered in a timely manner. It enables the company to maintain a level of liquidity.  In turn, this allows it to pay for its ongoing expenses.  Also, it provides a general idea of when the company can expand or make larger purchases.

Plan for future costs and schedule potential expenditures

Accurately knowing how long it takes to receive outstanding payments helps a company in many ways.  Management can prepare an effective plan for covering costs and scheduling potential expenditures to further growth.  The shorter the ACP is, the better it is for the company. It means that customers take less time to pay their bills. In other words, a lower ACP means the company collects payment faster.

However, too fast a collection period may simply mean the company has strict payment rules in place. The rules may work for some clients. But, stricter collection requirements can eventually end up turning some customers away.  Customers may look for companies with the same goods or services.  But, with more lenient payment rules or better payment options.

Collections by Industry

Not all businesses deal with credit, cash, or receivables in the same way.  Cash on hand is important to every business.  But, some rely more on their cash flow than others.  For example, the banking sector relies heavily on receivables.  This is due to the loans and mortgages it offers to consumers. Since it relies on income generated from these products, banks must have a strict turnaround time for receivables. If they have relaxed collection procedures and policies in place, income drops with catastrophic consequences.

Real estate and construction companies also rely on steady cash flows.  This is in order to pay for labor, services, and supplies. These industries don’t necessarily generate income as readily as banks.  So, it’s important that those working in these industries bill at appropriate intervals.  Sales and construction take time.  They may even be subject to seasonal delays.

Average Collection Period and the Collection Cycle

The ACP of a business allows management to measure their billing terms and processes. If the ACP is higher than the average credit period extended, it means the billing process is not working as it should. In many cases, this may be due to a simple lack of follow up.

Sometimes, it is a signal of un-credit-worthy customers.  A review can reveal that credit terms should have never been extended in the first place. To avoid this, companies should analyze their clients first, before extending credit lines to them. If a client has a history of late payments with other suppliers, cash terms might be a solution.  The company should not provide goods or services through credit.  The collection of such sales will probably be difficult. Additionally, administrative systems can provide the billing team with reminders of due invoices.  This will prompt them to follow up in order to reduce the ACP ratio.

No company wants a consistent record of failing to collect its payments on time.  That will eventually lead to financial difficulties due to cash shortages and an extended cash cycle. This can also lead to un-necessary expense.  The company will have to take additional debt to fulfill its commitments.  This debt carries interest charges that will reduce earnings. For this reason, the efficiency of any business collection process is a crucial element to its success.

ACP Use and Caution

A long Average Collection Period will usually be an indication of potential issues in the collection process.  The length by itself should not be the sole indication of this. Small to mid-sized companies with a small client base may be more susceptible to a significant increase in the overall average collection period if one of those clients start to be late on their payments.  Evaluating the ACP throughout time will probably give the analyst a much clearer picture of the behavior of a business’ payment collection situation. A sudden increase in the ACP should call for an in-depth analysis of what’s going on, as the reason for that increase could be that a particular client or project has been failing to meet its due dates for paying and given its size, it has affected the overall situation of the company’s receivables. (Source:invest-faq)

Up Next: What Is the Sustainable Growth Rate (SGR)?

The sustainable growth rate (SGR) is the maximum rate of growth that a company can sustain without having to issue additional equity or take on new debt. The SGR involves maximizing sales and revenue growth without increasing financial leverage. Achieving the SGR can help a company to grow without being over-leveraged and avoiding financial distress.

The sustainable growth rate is an indicator of what stage a company is in, during its life cycle. Understanding a company’s life cycle position can help determine corporate finance objectives.  Issues such as which sources of financing to use, dividend payout policies, and overall competitive strategy.

 

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