Understanding the Metrics’ SignificanceAverage collection period measures the time it takes a company to collect payments from customers on credit sales. As AR is listed as a current asset in balance sheets, businesses rely on this metric to ensure they have enough liquidity to meet their short-term obligations. A lower average collection period implies more efficient collections and strong financial health, while a longer one may indicate potential issues with cash flow or customer absorption costing explained with pros and cons and example payment practices. Most businesses rely on cash flow they have yet to receive from customers who have purchased their goods and services. You’ll also learn more about why this metric is so important, who should be involved in calculating it, and what actions you can take if your collections take too long. The average collection period is a financial metric that measures the average number of days it takes a company to collect payment from its customers after a sale has been made.
Manage your inventory and bookkeeping easier
Offer customers a range of payment options such as credit cards, direct deposits, and online payments. 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.
How Is the Average Collection Period Calculated?
This can negatively affect its sales and lower the number of potential customers. A decreasing average collection period is generally the trend companies like to see. Most of the time, this signals that the management has prioritized investment in collections and improved the collections processes. The average collection period calculation is often used internally for analyzing the company’s liquidity and the efficiency of its accounts receivable collections.
Financial Accounting II
However, an ongoing evaluation of the outstanding collection period directly affects the organization’s cash flows. By understanding the accounts receivable collection period, businesses can identify any issues that may lead to cash flow problems and take steps to address them. A lower average collection period usually means that a company has efficient collection practices, tight credit policies, or shorter payment terms. Finally, to find the value of the average collection period, you will need to divide the average AR value by total net credit sales and multiply the result by the number of days in a year. Finance professionals weigh multiple factors to determine the average performance of their company. One of the important factors that highlight turnover and cash flow management is the average collection period.
To find the average collection period of a company, you need to obtain its accounts receivable values from the balance sheet, along with its revenue for the same period. Ideally, you should use the company’s credit sales, but such specific information is not always available. A company’s average collection period gives an insight into its AR health, credit terms, and cash flow. Without tracking the ACP, it will become difficult for businesses to plan for future expenses and projects. Here are two important reasons why every business needs to keep an eye on their average collection period.
- As such, it is acceptable to use the average balance of AR over the same period of time as covered in the income statement.
- The average collection period is an accounting metric used to represent the average number of days between a credit sale date and the date when the purchaser remits payment.
- As it relies on income generated from these products, banks must have a short turnaround time for receivables.
- The average collection period is an indicator of the effectiveness of a firm’s AR management practices and is an important metric for companies that rely heavily on receivables for their cash flows.
- Regularly reviewing the average collection period enables companies to make informed decisions, optimize their collections processes, and maintain a positive relationship with their clients.
Make sure the same period is being used for both net credit sales and average receivables by pulling the numbers from the same balance sheets. Knowing the accounts receivable collection period helps businesses make more accurate projections of when money will be received. If your company’s ACP value continues to increase over time, it may indicate that your credit policies are too loose or payments are not collected efficiently. Sometimes, the rising trend may even signal the general worsening of the economy. The time they require to collect the money back from the customer is known as the accounts receivable collection period. Learning how to calculate average collection period will help your accounts receivables team to find where they stand and take action to shorten their score.
Yet, with the calculation of average collection period, you can predict and understand their creditworthiness. In the long run, you can compare your average collection period with other businesses in the same field to observe your financial metrics and use them as a performance benchmark. The average number of days between making a sale on credit, and receiving its due payment, is called the average collection period. The ACP is a calculation of the average number of days between the date credit sales are made, and the date that the buyer pays their obligation. According to a PYMNTS report, 88% of businesses automating their AR processes see a significant reduction in their DSO.
Utilize Effective Communication ChannelsEstablish clear communication channels with your clients. Regularly update them on due dates, offer multiple contact methods, and provide detailed invoice information to prevent misunderstandings that could delay payments. Let us take a look at a numerical example of calculating the average collection period.
The usefulness of average collection period is to inform management of its operations. This metric should exclude cash sales (as those are not made on credit and therefore do not have a collection period). To better illustrate how this formula works, let’s assume Rosie Dresses has a beginning balance in AR of $890,000, an ending balance of $780,0000, and annual sales of $2,650,000. Accordingly, the average AR will equal $890,000 plus $780,000 divided by two or $835,000.
When analyzing average collection period, be mindful of the seasonality of the accounts receivable balances. 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. At the same time, the management should keep in mind that if this period is very short, it might mean that its policies on credit sales are very strict.
Enforce strict payment terms and communicate the same with your current and future customers. Adjust your accounts receivable in line with this process and strategically manage both payment sections. The average collection period is the average value of the duration when a business collects its payments from its customers. Average collection period analysis can throw light on many takeaways that will help you understand your company more. The best average collection period is about balancing between your business’s credit terms and your accounts receivables.