What Is an Average Collection Period?
Average collection period is the time frame it takes for a company to collect payments due from its customers in the form of accounts receivable (AR). Businesses utilize the average collection time to ensure that they’ve got enough funds available to cover their obligations to the financial market. The collection period that is average is a measure of the efficiency of a company’s AR management strategies and is an important measure for businesses that depend heavily upon receivables to generate cash flow.
How Average Collection Periods Work
Accounts receivable is a commercial term that describes the amount that companies owe the company after they have purchased items or services. Businesses typically sell these items to customers through credit. AR is reported on companies’ balance sheets as current assets and is used to measure the extent of their liquidity. In this way, they show the ability of companies to pay off short-term debts without relying on cash flow flows that are not available.
The average period of collection can be described as an accounting measure that is used to measure the average amount of days that pass between the date of a credit sale until the time the purchaser makes payment. A company’s average collection time can be a sign of the efficiency of its AR management methods. Companies must be able to manage their collection periods in order to run smoothly.
A collection period that is shorter is generally preferable to an extended one. A shorter average period of collection suggests that the company is able to collect more quickly. This could indicate that the company’s credit terms are not as rigorous. Customers who do not feel that the lenders’ policies to be friendly might prefer to find vendors or providers who have more flexible terms for payment. 2
Formula for Average Collection Period
The average collection period is determined by dividing a business’s average balance of accounts receivable with its credit sales net over an exact time period, and then multiplying the result by all 365 days.
Average Collection Period = 365 Days * (Average Accounts Receivables / Net Credit Sales)
More frequently more commonly, the average collection time is defined as the number of days within a time duration divided by turnover ratio of receivables. The formula is called the ratio of days sales receivable.
Average Collection Period = 365 Days / Receivables Turnover Ratio
The average turnover of receivables can be described as the mean account sold receivables divided by the net sales. the formula below is an easier way of expressing the formula.
Average Accounts Receivables
The formulas above will help you calculate the average receivables can be calculated using the mean of the ending and beginning balances for a particular period. Advanced accounting tools might be able simplify the average of a company’s receivables for a specific period by taking into account the daily balances at the end of each day.
When you are analyzing the average collection period Be aware about how seasonality of the receivable balances. In the case of analyzing the peak month versus the slowest month could it will result in an extremely inconsistant balance of accounts receivable which could result in a skew of the total amount.
Net Credit Sales
The average collection period also depends on the net credit sales over an entire period. This measure should not include cash sales (as these are not based by credit and don’t have the benefit of a collection period).
Additionally, in addition to being restricted to credit sales only Net credit sales do not include residual transactions that can impact and, in many cases, reduce sales. This includes any discounts offered for customers products recalls or returns, as well as items which are re-issued as warranty items.
Importance of Average Collection Period
Average collection periods are reduced to one number However, it can be used for numerous uses and conveys various important details.
It shows how efficiently the debts are repaid. This is crucial because a credit sale will not completed until the company is paid. As long as cash is not collected the business is not yet to fully reap the benefits of the transaction.
It is a way to determine how strict the conditions for credit are. This is crucial because strict terms on credit can turn off customers while On the other hand credit terms that are too loose could be attractive to customers seeking to benefit from flexible payment terms.
It reveals the performance of competitors. This is crucial since all the data needed to determine the average collection time are available to public corporations. This will give you a better understanding of how other companies operate and how their operations stand up to.
It identifies early warning signs of poor allowances. This is vital because, when the time for collection grows, more customers are paying longer. This measure can be used to inform management that it is time to look at the outstanding receivables that are at risk of not being collected to ensure that clients are informed and monitored.
It reveals the company’s financial health in the short-term. It is vital because, without cash collection, a business may fail and be without the cash flow to pay its short-term expenses.
How to Use Average Collection Period
The average collection time doesn’t have much significance as a single number. Instead, you can make more value when you use it as a comparison tool.
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The best way companies can profit is to continuously calculate the period that it collects its most money over and using it in the course of time to look for patterns within their own company. The average collection time can also be used to assess the performance of the performance of a company against its competition in a grouping or individually together. Similar companies should have comparable financial indicators, and the average collection time can be used to measure against the performance of a different company.
Businesses can also evaluate the collection times of their customers and the credit terms offered to customers. For instance, a typical time to collect of 25 days doesn’t seem relevant if invoices are issued with the net 30 due date. But, a continuous analysis of the outstanding collection period directly impacts the flow of cash within the company.
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The typical collection period is usually not an externally mandatory figure to report. Also, it is not usually used as a financial obligation. The value of an average time to collect is to provide management with information about the company’s operations.
Example of Average Collection Period
As mentioned above as previously mentioned, the average period of collection is determined by dividing the total balance in AR by the total credit sales during the time period, and then multiplying the quotient by number of days within the period.
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Let’s say that a business is operating with an AR total of $10,000. The total net sales the company accumulated in this time period was $100,000. We will employ the following formula for the average collection period to calculate the time period:
($10,000 / $100,000) x 365 = Average Collection Period
The standard collection period is 36.5 days. This is a decent amount, given that the majority of companies have a collection period of 30 days. Recovering their receivables within an extremely short and reasonable timeframe allows the business to meet its obligations.
If the company’s typical period of collection was longer, say 60 days or more– it will have to implement more aggressive policies for collection to reduce the timeframe. If not, it might discover that it is not doing enough in terms of paying its own dues.
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Accounts Receivable (AR) Turnover
The average period of collection is closely tied to the ratio of turnover in accounts which calculates by divising the total net revenue by total AR balance.
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In the example above that the AR turnover is 10 ($100,000 10000). The average period of collection is also calculated by dividing days within the time period by the AR turnover. In this case the average collection time is exactly the same as the one before: 36.5 days.
10 = 365 days. Average Time to Collect
Collections by Industries
There aren’t all businesses that handle cash and credit in the same manner. While cash flow is essential to all businesses however, certain companies depend more on their cash flow in comparison to others.
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For instance the banking sector is reliant heavily on receivables as a result of the mortgages and loans it provides to customers. Because it depends on revenues from these services, banks should be able to provide a fast turnaround for receivables. If they do not have strict collection policies and procedures implemented, then revenue could drop, which can cause financial loss.
Construction and real estate companies depend on constant cash flow to pay for labour as well as supplies, services and. They don’t always earn as much as banks, therefore it’s essential that the people operating in these sectors make payments at the appropriate time since construction and sales require time and are susceptible to delays.
Why Is the Average Collection Period Important?
The length of time that a collection takes place indicates the effectiveness of an organization’s accounting receivables management strategies. This is vital for firms that heavily rely on receivables when it is about cash flow. Companies must be able to manage their collection time in a way that is consistent with they wish to have sufficient funds available to fulfill the financial requirements.
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How Is the Average Collection Period Calculated?
To determine the average period of collection divide the balance of accounts receivables by the total credit sales made during the time. Then, multiply the ratio by the total number of days in that particular period.
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If a business has an average balance in accounts receivable in the calendar year, of $10,000, and the total net sales are $100,000 and the average period for collection is (($10,000 ($10,000 x $100,000) (365 days)) which is 36.5 days.
Why Is a Lower Average Collection Period Better?
Businesses prefer a shorter average collection time in comparison to a longer one since it indicates that the business is able to efficiently recover its receivables.
The downside of the idea is it could suggest that the terms of credit for the company are not enough. More stringent terms could lead to the loss of customers to companies with more flexible terms for payment.
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How Can a Company Improve its Average Collection Period?
A business can increase the average time to collect by implementing a variety of strategies. It is able to establish stricter credit conditions, limiting the amount of time an invoice can be in arrears. It could also limit the number of customers that it provides credit to in order to boost the cash sales. They can also offer price discounts on payments made earlier (i.e. 2percent discount if you pay within just 10 days).
The Bottom Line
The period of collection is the amount of days required to allow a credit sale be paid. In this time the business is offering its client a short-term “loan” and the faster the customer is able to collect it, the sooner it will have money to expand the company or pay invoices. Although a shorter time to collect is usually superior, too rigid credit terms can turn customers away.
Importance of Average Collection Period
The average collection period is reduced to a single number However, it can be used for numerous uses and conveys various important details.
It shows how efficiently the debts are repaid. This is crucial since a credit sale is not completed until the company is paid. As long as cash is not collected the company has yet to fully reap the benefits of the transaction.
It is a way to determine how strict the terms for credit are. This is vital since strict credit terms could turn off customers however, On the other hand credit terms which are too loose can draw customers who want to benefit from the softer payment terms.
It reveals the performance of competitors. This is vital since all data required to determine the average collection period are readily available in public company. This will give you a better understanding of how other companies operate and how the operations of a particular company are compared to.
It identifies early warning signs of poor allowances. This is vital because, when the time for collection grows, more customers are waiting longer to pay. This measure can be used as a signal to management that it is time to look at the outstanding receivables that are at risk of not being collected to ensure that customers are informed and monitored.
It reveals the financial health of a business in the short term. This is crucial because, without cash collections, a business is likely to fail and not have the funds to pay for its bills in the short term.
How to Use Average Collection Period
The average collection time is not a significant value as a standalone data point. Instead, you can make more value when you use it as a tool for comparing.
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The best way an organization can gain is to keep track of its typical collection period and then using it to look for patterns within their own company. The average collection period can also be used to evaluate the performance of a company against its competition whether individually or together. Similar companies will have similar financial indicators, and the average collection time can be used to measure against the performance of a different company.
Businesses can also evaluate the collection times of their customers and the terms for credit that are that are extended to customers. For instance, an average time to collect of 25 days doesn’t seem relevant if invoices are issued with the net 30 due date. But, a continuous evaluation of the collection period that is still outstanding directly impacts the cash flow.
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The typical collection period is not a commonly obligatory figure to be reported. Also, it is not usually considered a financial covenant. The purpose of a typical time to collect is to provide management with information about the company’s operations.
Example of Average Collection Period
As previously mentioned The average collection period is calculated by dividing amount of the average account AR by the total net credit sales during the entire period, then multiplying the result by the number of days of the time period.
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Let’s suppose that a company is operating with an AR total of $10,000. The net sales the company made in this time period was $100,000. We will employ the following formula for the collection period’s average to calculate the time period:
($10,000 / $100,000) x 365 = Average Collection Period
The typical collection time is 36.5 days. This is a decent number, as most businesses are able to collect their debts within 30 days. The ability to collect its receivables over an extremely short and acceptable time frame will allow the business time to settle its debts.
If the average time to collect was more long, say more than 60 days– it will have to implement an aggressive policy of collection to reduce the timeframe. In the event that it does not, it could discover that it is not doing enough in terms of paying its own obligations.
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Accounts Receivable (AR) Turnover
The average period of collection is closely linked to the ratio of turnover in accounts which calculates by divising the total net revenues by an total AR balance.
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Based on the previous example that the AR turnover is 10 ($100,000 10000). The average collection time is also calculated by dividing the number days during the time frame divided by AR turnover. In this instance the average collection time is exactly the same as the one before: 36.5 days.
10 = 365 days. Average Time for Collection
Collections by Industries
There aren’t all businesses that handle cash and credit in the same manner. While cash flow is crucial to all businesses certain businesses depend more on their cash flow more than others.
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For instance the banking industry relies heavily on receivables due to the mortgages and loans they offer to consumers. Because it depends on revenues from these services, banks should have a quick turnaround time for receivables. If they do not have strict practices and procedures in place, then their income could drop, which can cause financial loss.
Construction and real estate companies depend on constant cash flow to cover labor or services as well as other supplies. They don’t always earn as much as banks, therefore it’s essential that the people operating in these sectors pay their bills on time since construction and sales take time and can be susceptible to delays.
Why Is the Average Collection Period Important?
The time frame for collection is a good indicator of the efficiency of an organization’s accounting receivables management strategies. This is vital for businesses that heavily depend on receivables when it is about cash flow. Businesses need to control their collection time in a way that is consistent with they wish to have sufficient funds available to meet the financial requirements.
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How Is the Average Collection Period Calculated?
To calculate the average time to collect Divide the balance of accounts receivables by the total credit sales made during the time. Then multiply the result times the amount days that occurred during the specific time period.
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For instance, if a business has an average receivables balance of $10,000 and total revenues of $100, the average period for collection is (($10,000 $ 100,000 / $100,000) (365 days)) which is 36.5 days.
Why Is a Lower Average Collection Period Better?
Businesses would prefer a shorter time to collect over a longer one because it shows that the business is able to efficiently recover its receivables.
The disadvantage of this could suggest that the terms of credit for the company aren’t enough. The stricter terms can lead to losing customers to rivals who have more flexible payment terms.
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How Can a Company Improve its Average Collection Period?
An organization can enhance its collection time by implementing a variety of strategies. It could set more stringent credit conditions that limit the length of time that an invoice is permitted to be in arrears. This could also mean limiting the number of customers that it provides credit to, in order to boost cash sales. Additionally, it can offer discounts on payments made earlier (i.e. 20% discount when paid within just 10 days).
The Bottom Line
The collection period for an average is the number of days that it takes to allow a sale of credit be paid. In this time the business is offering its customer a short-term “loan” and the faster the customer can pay back it, the sooner it will have money to expand its business or pay its invoices. Although a shorter average time to collect is usually superior, too restrictive credit terms could turn customers away.
