Average Collection Period Formula, How It Works, Example

The average collection period is an important metric to consider when looking at your business. Let’s say that your small business recorded a year’s accounts receivable balance of $25,000. A company would use the ACP to ensure that they have enough cash available to meet their upcoming financial obligations. Companies prefer a lower average collection period over a higher one as it indicates that a business can efficiently collect its receivables. Let us now do the average collection period analysis calculation example above in Excel.

How is the Average Collection Period Formula Derived?

1. Calculating the average collection period with average accounts receivable and total credit sales.
2. It refers to how quickly the customers who bought goods on credit can pay back the supplier.
3. The average receivables turnover is simply the average accounts receivable balance divided by net credit sales; the formula below is simply a more concise way of writing the formula.
4. 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.

Once we know the accounts receivable turnover ratio, we can do the average collection period ratio. It may mean that the company isn’t as efficient as it needs to be when staying on top of collecting accounts receivable. However, the figure can also represent that the company offers more flexible payment terms when it comes to outstanding payments. This would show that your average collection period ratio of the year is around 46 days. Most businesses would aim for a lower average collection period due to the fact that most companies collect payments within 30 days.

It is very important for companies that heavily rely on their receivables when it comes to their cash flows. Businesses must manage their average collection period if they want to have enough cash on hand to fulfill their financial obligations. As noted above, the average 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 (ACP) is a metric that reveals the average time it takes for a company to collect payments from customers for credit sales. It measures the company’s efficiency in converting accounts receivable into cash. 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.

Customers who don’t find their creditors’ terms very friendly may choose to seek suppliers or service providers with more lenient payment terms. 🔎 Another average collection period interpretation is days’ sales in accounts receivable or the average collection period ratio. 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).

How to Interpret an Increased Average Collection Period

You need to calculate the average accounts receivable and find out the accounts receivables turnover ratio. So if a company has an average accounts receivable balance for the year of $10,000 and total net sales of $100,000, then the average collection period accountant the would be (($10,000 ÷ $100,000) × 365), or 36.5 days. The average receivables turnover is simply the average accounts receivable balance divided by net credit sales; the formula below is simply a more concise way of writing the formula. Or multiply your annual accounts receivable balance by 365 and divide it by your annual net credit sales to calculate your average collection period in days for the entire year.

Since the company needs to decide how much credit term it should provide, it needs to know its collection period. We will take a practical example to illustrate the average collection period for receivables. In 2020, the company’s ending accounts receivable (A/R) balance was $20k, which grew to $24k in the subsequent year. The ACP figure is also a good way to help businesses prepare an effective financial plan.

Maintaining Liquidity

It’s vital for companies to receive payment for goods or services in a timely manner. It allows the business to maintain a good level of liquidity which allows it to pay for immediate expenses. It also allows the business to get a good idea of when it may be able to make larger, more important purchases.

A company’s average collection period is a key indicator, offering a clear window into its AR health, credit terms, and cash flow. By forecasting cash flow from accounts receivable, businesses can proactively plan expenses, strategically navigating the dynamic landscape of credit sales. In order to calculate the average collection period, divide the average balance of accounts receivable by the total net credit sales for the period. Then multiply the quotient by the total number of days during that specific period. The average collection period indicates the effectiveness of a firm’s accounts receivable management practices.

When analyzing average collection period, be mindful of the seasonality of the accounts receivable balances. cpa vs mba salary 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. For example, financial institutions, i.e., banks, rely on accounts receivable because they offer their customers credit loans, installments, and mortgages. 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.

Free Financial Modeling Lessons

In the next part of our exercise, we’ll calculate the average collection period under the alternative approach of dividing the receivables turnover by the number of days in a year. As an alternative, the metric can also be calculated by dividing the number of days in a year by the company’s receivables turnover. For the formulas above, average accounts receivable is calculated by taking the average of the beginning and ending balances of a given period. More sophisticated accounting reporting tools may be able to automate a company’s average accounts receivable over a given period by factoring in daily ending balances. A lower average collection period is generally more favorable than a higher one. A low average collection period indicates that the organization collects payments faster.

Here are two important reasons why every business needs to keep an eye on their average collection period. Real estate and construction companies also rely on steady cash flows to pay for labor, services, and supplies. Accounts receivable is a business term used to describe money that entities owe to a company when they purchase goods and/or services. AR is listed on corporations’ balance sheets as current assets and measures their liquidity. As such, they indicate their ability to pay off their short-term debts without the need to rely on additional cash flows.

While ACP holds significance, it doesn’t provide a complete standalone assessment. It’s essential to compare it with other key performance indicators (KPIs) for a clearer understanding. If the company decides to do the Collection period calculation for the whole year for seasonal revenue, it wouldn’t be just. By submitting this form, you consent to receive email from Wall Street Prep and agree to our terms of use and privacy policy.

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. 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. It means that Company ABC’s average collection period for the year is about 46 days. It is slightly high when you consider that most companies try to collect payments within 30 days.

Every business has its average collection period standards, mainly based on its credit terms. 🔎 You can also enter your terms of credit in our calculator to compare them with your average collection period. Once you have the required information, you can use our built-in calculator or the formula given in the next section to understand how to find the average collection period. A fast collection period may not always be beneficial as it simply could mean that the company has strict payment rules in place.

It may mean that your business isn’t efficient enough when it comes to staying on top of collecting its accounts receivable. However, it can also show that your credit policy is one that offers more flexible credit terms. At the beginning of the year, your accounts receivable were at $5,000, which increased to $10,000 by year-end. In this article, we explore what the average collection period is, its formula, how to calculate the average collection period, and the significance it holds for businesses. More specifically, the company’s credit sales should be used, but such specific information is not usually readily available. Thus, the average collection period signals the effectiveness of a company’s current credit policies and A/R collection practices.