In the first formula, we first need to determine the accounts debtor collection period formula receivable turnover ratio. 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.
An increase in the receivables collection period can be a cause for concern, as it suggests potential issues in the cash flow cycle. For instance, a company may experience a higher number of customers with delayed payment patterns, indicating potential credit risks. Additionally, changes in economic conditions or industry dynamics can impact customer payment behaviour, leading to extended collection periods.
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. Calculating the average collection period with average accounts receivable and total credit sales. 💡 You can also use the same method to calculate your average collection period for a particular day by dividing your average amount of receivables by your total credit sales of that day. The average collection period is closely related to the accounts turnover ratio, which is calculated by dividing total net sales by the average AR balance.
For example, in the above example, the account receivable collection period is compared with the credit period allowed to the customers. When businesses make sales for cash, the administration of the sales and any cash generated from these sales becomes fairly easy. However, when businesses make sales on credit, they must bear extra administrative overhead to ensure the cash is received on time.
- As many professional service businesses are aware, economic trends play a role in your collection period.
- It means that Company ABC’s average collection period for the year is about 46 days.
- Efficient cash flow management is important for any business’s financial stability and growth.
- In other words, it refers to the time it takes, on average, for the company to receive payments it is owed from clients or customers.
- Businesses must be able to manage their average collection period to operate smoothly.
- 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.
Example of the average collection period
However, lower account receivable collection periods may also indicate aggressive credit control behaviors. For example, the credit control of the business calls their customers every day and threaten with legal action in case of failure to repay their balance within time. Businesses should ensure that it is kept at an optimal level while ensuring the satisfaction of the customers. This can also easily be calculated in number of weeks or months if the credit periods are longer.
Strategies to Improve Debtor Collection Period
Businesses base their credit limits and credit periods on their historical data such as the account receivable collection period. For example, if the business has a very high account receivable collection period, it may reduce its credit limits or periods to reduce it. Furthermore, decisions regarding whether customers should be offered early settlement discounts can be made by considering the account receivable collection period of the business. The receivables collection period ratio interpretation requires a comprehensive understanding of the company’s industry, business model, and credit policies.
Implementing an efficient and automated invoicing system can enhance accuracy and timeliness while reducing manual errors. Additionally, utilising online payment platforms and providing multiple payment options can facilitate faster and smoother transactions, reducing the collection period. To address an increasing collection period, companies can employ various strategies. First, they can review and strengthen their credit policies, ensuring that credit terms are clear, reasonable, and aligned with industry standards.
How to Calculate Your Average Collection Period
Ideally, it should be lower or, at the very least, equal to the number of days that the business allows its customers to pay for credit sales. For businesses that rely heavily on cash sales rather than credit sales, this may even be zero or close to zero. To calculate this metric, you simply have to divide the total accounts receivable by the net credit sales and multiply that number by the number of days in that period — typically, this is 365 days.
Suppose a company generated $280k and $360k in net credit sales for the fiscal years ending 2020 and 2021, respectively. Knowing the average collection period for receivables is very useful for any company. Companies prefer a lower average collection period over a higher one as it indicates that a business can efficiently collect its receivables.
In this example, the graphic design business has an average receivables’ collection period of approximately 10 days. This means it takes around 10 days, on average, for the business to collect payments from their clients for credit sales. Industries such as banking (specifically, lending) and real estate construction usually aim for a shorter average collection period as their cash flow relies heavily on accounts receivables.