In business, companies often have to wait for payments from customers, and that period is generally known as the average collection period.
Also known as the average collection period ratio and the ratio of days to sales outstanding, the average collection period is defined as the period of time it takes to collect on a product or services invoice. The "average" component is the formula used to measure the time it takes to get paid measured by days, (expressed in business terms as the "accounts receivable.")
Pulling the lens back, the average collection period accounts for the day a sale is made to a customer and recorded as such (also known as a "credit") to the date the seller receives the payment and deposits it for payment.
Ideally, companies have a target in sight for buyer payment time frames, and the average collection period calculation provides the data that shines a light on that time frame. The goal, by and large, is to get paid within an average collection period that is roughly 33% lower than the bill invoice payment date.
Thus, a company that issues credit payment terms of 45 days is seeking payment by 30 days (although individual businesses may have their own ideal average collection periods.)
Calculating the Average Collection Period
Calculating the average collection period is completed using a standard account formula, as follows:
Start with the number of days (usually 360-to-365 days to account for a full calendar year) divided by the account receivables turnover ratio.
Or, companies can calculate the average collection period as the average accounts receivable balance, divided by the average credit sales on a daily basis.
According to data from AccountingForManagement.com, the general calculation would be completed as follows:
- Total sales for company XYZ Corporation: $176,000
- Cash sales: $77,000
- Accounts receivables - (closing): $8,000
- Notes receivables - (closing): $3,000
Now, the company calculates the average collections period as 360 (period of working days) divided by nine (debtor's turnover ratio) = 40 days.
Thus, XYZ Corp.'s average collection period is 40 days. That's the average time the company has to wait to get paid by creditors.
Why Is the Average Collection Period Important?
The average collection period is important for a number of reasons, but there are several that rise to the top of the list:
The Need to "Go Lower" - to a Point
Companies that calculate average collection periods are looking for payout time ratios that are lower, meaning the firm is getting paid more quickly.
This isn't necessarily a major plus for companies, as buyers may deem the selling company's credit terms as too strict, and their payment turnaround times too short. That scenario could be enough to steer buyers to sellers with more amenable and longer payment timetables.
A Useful Comparison Tool
Average collection period, by itself, may not hold a singular value to a business. While keeping tabs on the average collection metric over time, say a quarter or a year, does hold value, it's more useful for a business to use their own average collection period as a barometer against other companies in its field.
If, for example, a company finds that it's getting paid more quickly than its competitors, while still holding on to its customers, that is considered a strategic advantage by corporate finance professionals.
A Strategic Financial Tool
The average collection period can give a company-specific financial gain if it's getting paid more quickly, as measured by time against accounts receivable.
For instance, if a business is cycling cash flow faster, it can more easily qualify for credit or loans, at better interest rates, and with more reputable lenders and investors.
What Metrics Do You Need for Average Collection Period?
Getting a better grip on average collection period means getting a grip on two key components - average accounts receivable and net credit sales.
What Are Average Accounts Receivable?
A company's average accounts receivable is a helpful metric tied to incoming payments. In a word, the term is considered an activity ratio which figures out the number of times a business can flip its accounts receivables into cash over a specific time frame (for example, one year.)
The calculation for accounts receivable turnover is fairly straightforward - simply divide net credit sales by the average accounts receivable for a given time period.
By applying average accounts receivable calculations, companies can better ascertain how effective a business is in getting paid as quickly as possible by its buyers.
After all, there are big differences in getting paid in a 45-day payment cycle as opposed to a 90-day payment cycle for a business, and the average accounts receivable is a valuable metric in figuring the time of customer payments out. Thus, turning accounts receivables into liquid cash is a big deal for businesses - they want to do so as often as possible over a given time period.
For example, consider a business that had $25,000 of average account receivables over the course of a single year. Also, assume the business was paid $50,000 in receivables in the same time period.
According to the rules of average accounts receivables, that company would have converted its accounts receivables two times, as it received two times the figure of average receivables.
Calculating Accounts Receivable Turnover Ratio
Accounts Receivable Turnover Ratio = Net Credit Sales/Average Accounts Receivable
What Is Net Credit Sales?
Another metric that's highly helpful in calculating the average collection period is net credit sales.
Net credit sales are the revenues accumulated by a company from a customer via credit, minus any sales rebates, returns or sales-related allowances. Net credit sales do not account for any customer purchases made immediately - they're for sales made and payments rendered over a specific time period.
By and large, companies aim to be tighter rather than looser with credit sales terms.
Any net credit sales figure that trends higher means the company isn't managing its credit outlays adequately, or that it's too lenient in green-lighting sales returns (i.e., sales returns return to a customer service problem, like late delivery) or sales allowances (i.e., a "make good" discount price for a customer who had a previous problem with a company product.)
Calculate net credit sales in the following manner:
Sales on credit minus sales returns minus sales allowances = net credit sales.
Average Collection Period - an Important Business Metric
Having a way to calculate the performance level of a company's credit issuing and payment receiving capabilities is strongly beneficial in improving that company's cash flow situation, and by extension, its bottom line.
That's what the average collections period can provide, and in a clear-cut way that shines a much-needed light on a business's financial performance - for now and for well into the future.