What Is Average Collection Period Ratio Formula and How to Calculate It

August 31, 2021 | aporadix

Companies should review their average collection period regularly, ideally monthly or quarterly, to quickly identify and address any potential issues in credit policies, collections processes, or cash flow. This means your company’s locking up less of its funds in accounts receivable, so the money can be used for other purposes. Additionally, a lower number reduces […]

Companies should review their average collection period regularly, ideally monthly or quarterly, to quickly identify and address any potential issues in credit policies, collections processes, or cash flow. This means your company’s locking up less of its funds in accounts receivable, so the money can be used for other purposes. Additionally, a lower number reduces the risk of customer defaults and likely reflects that payments are being made on time, depending on your billing cycle. From 2020 to 2021, the average number of days needed by our hypothetical company to collect cash from credit sales declined from 26 days to 24 days, reflecting an improvement year-over-year (YoY). As an alternative, the metric can also be calculated by dividing the number of days in a year by the company’s receivables turnover. The average collection period measures a company’s efficiency at converting its outstanding accounts receivable (A/R) into cash on hand.

Benefits of Calculating Your Average Collection Period

Encourage customers to automate their payments or pay in advance with early payment discounts. You can also consider charging late fees for overdue payments, either as a flat rate or a monthly finance charge, usually a percentage of the overdue amount. Like most accounting metrics, you’ll need some context to determine how this number applies to your finances and collection efforts.

Unlocking the Potential of Excel’s Data Dashboard

These types of businesses rely on customers to pay in cash to ensure that they have enough liquidity to pay off their suppliers, lenders, employees, and other trade payables. Upon dividing the receivables turnover ratio by 365, we arrive at the same implied collection periods for both 2020 and 2021 — confirming our prior calculations were correct. If your company requires invoices to be paid within 30 days, then a lower average than 30 would mean that you collect accounts efficiently. An average higher than 30 can mean that you’re having trouble collecting your accounts, and it could also indicate trouble with cash flow.

B. Comparing the results to industry benchmarks

Business owners and managers must closely monitor the metric to ensure that the company has enough cash available to cover its short-term financial obligations. In this article, we are going to take a look at how to calculate and analyze the average collection period. Companies typically favour a lower average collection period because it means there’s a shorter time between converting your average balance from accounts receivable to cash. The receivables turnover can use the total accounts receivable at the end of a period or the average throughout the period.

B. Utilizing built-in Excel functions for calculations

A short and precise turnaround time is required to generate ROI from such services (you can find more about this metric in the ROI calculator). Thus, by neglecting their policies for managing accounts receivable, they can potentially have a severe financial deficit. Calculating the average collection period with accounts receivable turnover ratio. Real estate what is balance sheet definition of balance sheet, balance sheet meaning and construction companies also rely on steady cash flows to pay for labor, services, and supplies. If this company’s average collection period was longer—say, more than 60 days— then it would need to adopt a more aggressive collection policy to shorten that time frame. Otherwise, it may find itself falling short when it comes to paying its own debts.

A. Understanding what the average collection period signifies

  1. A decreasing average collection period is generally the trend companies like to see.
  2. For example, analyzing a peak month to a slow month by result in a very inconsistent average accounts receivable balance that may skew the calculated amount.
  3. When evaluating your ACP, you want to look at how it stacks up to your credit terms and when you’re actually collecting payment.
  4. Generally, the average collection period is an important internal metric used in the overall management of a company’s finances.

However, if the shorter collection period is due to overly aggressive collection practices, it runs the risk of straining customer relationships, potentially leading to lost business. Also, keep in mind that the average collection period only tells part of the story. To really understand your accounts receivables, you need to look at this metric in tandem with related metrics like AR turnover, AR aging, days payable outstanding (DPO), and more. For instance, consumers and businesses often face financial constraints during recessions or economic instability. Consequently, this may delay payments or lead to higher defaults on invoices — resulting in longer average collection periods as companies struggle to collect on outstanding receivables.

As we’ve seen, Excel is a powerful tool for financial analysis and decision-making. I encourage all readers to apply their Excel skills to delve deeper into their company’s financial data and drive better outcomes for their business. With the right tools and knowledge, Excel can be a game-changer in optimizing financial management and achieving business success. Because it represents an average, customers who pay very early or extremely late can skew your results. Liquidity is your business’s ability to convert assets into cash to pay your short-term liabilities or debts. The average collection period is an important metric to consider when looking at your business.

If you were to simply use your ending AR balance, your results might be skewed by a particularly large or small year-end balance. Whenever you have bills that you’re scheduled to pay, it’s important to keep track of how much you owe. You should always be monitoring your cash solvency so that you are sure you have enough capital available to take care of your financial responsibilities.

In this article, we will explore strategies for reducing the average collection period and how to implement changes based on Excel analysis. The average collection period is determined by taking the net credit sales for a given period and dividing the average accounts receivable balance by the company’s net credit sales. As noted above, the average https://www.simple-accounting.org/ collection period is calculated by dividing the average balance of AR by total net credit sales for the period, then multiplying the quotient by the number of days in the period. The average collection period is a metric used in accounting to represent the average number of days it takes a company to collect payment after a credit sale.

In today’s business landscape, it’s common for most organizations to offer credit to their customers. After all, very few companies can rely solely on cash transactions for all their sales.If your business follows suit by extending credit to customers, it becomes crucial to efficiently manage payment collections. Similarly, a steady cash flow is crucial in construction companies and real estate agencies, so they can pay their labor and salespeople working on hourly and daily wages in a timely manner. Also, construction of buildings and real estate sales take time and can be subject to delays. So, in this line of work, it’s best to bill customers at suitable intervals while keeping an eye on average sales. For example, financial institutions, i.e., banks, rely on accounts receivable because they offer their customers credit loans, installments, and mortgages.

On the other hand, if the same company issues invoices with a 30-day due date, an ACP of 50 days would be considered very high. If Company ABC aims to collect money owed within 60 days, then the ACP value of 54.72 days would indicate efficiency. However, if their target collection period is 30 days, the ACP value of 54.72 days would be too high, indicating inefficiency in the company’s collection efforts. Log all payments and communication with customers so you can easily track and follow up if necessary. Learn how QuickBooks small business accounting solutions can improve your invoicing processes, budgeting practices and more. When evaluating your ACP, you want to look at how it stacks up to your credit terms and when you’re actually collecting payment.

These issues have pushed businesses to further streamline their accounts receivable process by implementing several key metrics and procedures to maintain liquidity. Lastly, the average collection period is a metric for evaluating the current credit arrangements and determining whether changes should be made to improve the working capital cycle. The time it typically takes to collect payment from your customers after you’ve delivered a product or services. The average collection period should be used in your financial model to accurately forecast how and when new customers will contribute to your cashflow. Suppose a company generated $280k and $360k in net credit sales for the fiscal years ending 2020 and 2021, respectively.

It also looks at your average across your entire customer base, so it won’t help you spot specific clients that might be at risk of default. You’ll need to monitor your accounts receivable aging report for that level of insight. On the other hand, if your results are better than average, you know you’re operating efficiently, and cash flow might be a competitive advantage. On average, it takes Light Up Electric just over 17 days to collect outstanding receivables. Let’s say you own an electrical contracting business called Light Up Electric. At the beginning of the year, your accounts receivable (AR) on your balance sheet was $39,000.