Understanding how long it takes a company to recoup its investment in inventory and raw materials is critical in calculating the length of its cash cycle. The cash cycle counts the number of days it takes for a firm to recoup its investment from the time it submits a purchase order to the time it collects the proceeds from a sale. The average collection period is the number of days it takes a company to collect its receivables on average. It represents the efficiency of the collection process. The lower it is, the shorter the business’s cash cycle, which has a favorable impact on its profitability. Let’s see the formula and ways of calculating the average collection period.
What Is the Average Collection Period?
The average collection period is the length of time it takes for a corporation to collect its accounts receivable (AR). It refers to the average time it takes for the company to receive the money its clients or consumers owe. A business has to manage the average collection period effectively to ensure that a company has adequate cash on hand to meet its short-term financial obligations.
To be clear, the average collection period is a calculation of the average number of days between the date a transaction is made (on credit) and the date the buyer submits payment or the date the company gets payment from the buyer.
How Do They Work?
Accounts receivable refers to money owed to a corporation by entities when they acquire goods and/or services. Companies typically make these credit-based sales to their customers. AR is shown as a current asset on a company’s balance sheet and measures its liquidity. As so, they demonstrate their ability to pay off short-term loans without relying on further income flows.
The average collection period is an accounting indicator that represents the average number of days between the date of credit sale and the date of payment remittance by the purchaser. The average collection period of a corporation reflects the effectiveness of its AR management strategies. To run smoothly, businesses must be able to manage their average collection period.
In general, a smaller average collection period is preferable to a higher one. A short average collection period suggests that the organization receives payments more quickly. However, there is a disadvantage to this, since it may imply that the company’s credit terms are excessively stringent. Customers who are dissatisfied with their creditors’ payment conditions may choose to seek suppliers or service providers with more liberal payment terms.
The average balance of AR is computed by adding the opening and closing balances of AR and then dividing the total by two. For the sake of simplicity, when calculating the average collection period for a whole year, we choose 365 as the number of days in one year. More information on the formula that is used to calculate the average collection period is provided below.
The Importance of Average Collection Period
#1. Preserve liquidity
Clearly, receiving payment for goods or services given in a timely manner is critical for a business. It allows the company to maintain a level of liquidity, allowing it to pay for immediate needs and obtain a sense of when it might be able to make larger acquisitions.
#2. Budget for future expenses and set aside money for them
The average collection period ratio is particularly crucial from a timing standpoint, as it can assist a company in developing an effective plan for covering costs and arranging possible investments to further growth.
The shorter the average collection period, for obvious reasons, the better for the company. It signifies that a company’s customers pay their invoices more quickly. Another way to look at it is that a shorter average collection period indicates that the company receives payment more quickly.
A short collection period may not always be advantageous because it may merely indicate that the organization has rigorous payment policies in place. The rules may be appropriate for some clients. Stricter collection criteria, on the other hand, may push away certain clients, prompting them to hunt for organizations that offer the same goods or services but have more flexible payment restrictions or better payment choices.
The Formula For Calculating the Average Collection Period
The formula for calculating the Average Collection Period is as follows:
ACP = 365 / Accounts Receivable Turnover
Average Collection Period Formula
The Accounts Receivable Turnover rate illustrates how many times a company’s net credit sales are converted into cash in a given year or time period. The formula for calculating the Accounts Receivable Turnover rate is as follows:
Net Credit Sales / Average Accounts Receivables = ART
Consider the following example to further demonstrate the formula for calculating the average collection period in action. Assume Company ABC has a yearly accounts receivable balance of $25,000. The company made $200,000 in total net sales that year.
The first step in determining the average collection period for the company is to split $25,000 by $200,000. Because the calculation is to establish the average collection period for the year, the you must multiply the quotient by 365.
From our example, the average collection period calculation looks like this:
(25,000 / 200,000) * 365 = 45.6
It suggests that for the entire year, Company ABC’s average collection period is around 46 days. When you consider that most businesses aim to collect money within 30 days, it seems a little high.
The average collection period figure for the company can signify a few different things. It could imply that the company isn’t as efficient as it should be when it comes to collecting accounts receivable. However, the figure could also indicate that the corporation offers more flexible payment arrangements for outstanding invoices.
What Does an Increased Average Collection Period Mean?
An increase in the average collection period could be a sign of any of the problems listed below.
#1. Credit Policy Is Lax
Management has opted to extend more credit to clients, maybe in order to boost sales. This could also imply that certain customers have a longer grace period before having to settle overdue debts. This is especially typical when a small business wishes to sell to a large retail chain. It can guarantee a significant increase in sales in exchange for long payment terms.
#2. Worsening Economic Situation
Customers’ cash flows may be impacted by general economic conditions, prompting them to postpone payments to their suppliers.
#3. Collection Efforts are Reduced
There could be a decrease in financing for the collections department or an increase in worker turnover. In either situation, collections receive less attention, resulting in a rise in the quantity of receivables outstanding.
Read Also: SPECIFIC IDENTIFICATION METHOD: Applications In Accounting
How to Interpret a Shortening of the Average Collection Period
A decrease in the average collection period may indicate the following:
#1. Stricter Credit Policy
Management may limit credit to customers for a variety of reasons. This includes anticipating a fall in economic conditions or not having adequate working capital to support the existing level of accounts receivable.
#2. Simplified Terminology
Customers may have been given shorter payment terms by the company.
#3. Enhanced Collection Efforts
Management may decide to boost the collections department’s staffing and technological support, which should result in a reduction in the amount of past-due accounts receivable.
Why Is a Shorter Average Collection Period Preferable?
Companies prefer a shorter average collection period to a higher one since it suggests that a company can collect its receivables efficiently.
The disadvantage of this is that it may suggest that the company’s loan terms are overly stringent. Stricter payment terms may result in customers fleeing to competitors with more forgiving payment terms.
Industries’ Collections
Not every firm handles credit and cash in the same way. Although cash on hand is vital for all businesses, some rely more on it than others.
For example, the banking industry is significantly reliant on receivables due to the loans and mortgages it provides to customers. Banks must have a quick turnaround time for receivables because they rely on the income generated by these products. Income would fall if they had slack collection procedures and standards in place, creating financial loss.
Real estate and construction firms rely on consistent cash flows to pay for labor, services, and materials as well. Because these industries do not create cash as quickly as banks, it is critical that employees working in them bill at suitable intervals. This is because sales and construction take time and maybe vulnerable to delays.
Analysis of the Average Collection Period
Calculating a company’s average collection period allows the management team to assess the efficiency of their billing teams and processes. If the ACP is greater than the average credit period granted to clients, as seen in the example above, it indicates that the Billing Process is not functioning properly. Most of the time, this is due to a lack of follow-up or to substandard credit lines that should never have been issued in the first place.
To avoid this, businesses should do a thorough analysis of their clientele before offering credit lines to them. If a client has a history of late payments with other suppliers, the company should not sell goods or services on credit because the collection will be difficult. Additionally, administrative systems should send notifications of past-due invoices to the billing team to encourage them to follow up in order to minimize the ratio.
A corporation that has a regular track record of failing to collect payments on time may eventually face financial challenges owing to cash shortages when its cash cycle is stretched. This is also a costly position because the corporation will have to incur debt to meet its obligations. Also, this debt will incur interest charges hence, reducing earnings. As a result, the effectiveness of any business collection procedure is critical to its success.
Conclusion
Finally, while a long Average Collection Period is usually a sign of possible problems in the collection process, it should not be the only one. Small to mid-sized businesses with a small client base, particularly those that rely on a few important clients for the majority of their revenue, may be more vulnerable to a considerable rise in the total average collection period if one of those clients falls behind on their payments.
As a result, analyzing the evolution of the ACP over time will most likely provide the analyst with a much clearer picture of the behavior of a business’ payment collection problem. A sudden increase in the ACP should prompt an in-depth investigation of what is going on. This is because the cause of the increase could be that a specific client or project has been failing to meet its payment due dates, and because of its size, it has impacted the overall situation of the company’s receivables.
Average Collection Period FAQs
Should average collection period be high or low?
Companies prefer a shorter average collection period to a higher one since it suggests that a company can collect its receivables efficiently.
How do you calculate average collection period?
You can calculate the average collection period by dividing a company’s yearly accounts receivable balance by total net sales for the year; this value is then multiplied by 365 to give a number of days.
What is a good average collection period?
If your organization offers credit terms of 30 days to its clients but your average collection period is 45 days, this is a problem. However, it is advantageous if your average collection period is fewer than 30 days.
