The average collection period of accounts receivable is the average number of days it takes to convert receivables into cash. It also marks the average number of days it takes customers to pay their credit accounts.
Learn more about this figure and why businesses would want to track it.
What Is the Average Collection Period?
When a company provides a good or service without expecting payment right away, it creates an account receivable. The business won't be paid right away, but it will be paid eventually. The average collection period is a measure of how long it takes it usually takes a business to receive that payment. In other words, this financial ratio is the average number of days required to convert receivables into cash.
- Alternate names: Average collection period ratio, ratio of days to sales outstanding
You can calculate your business's average collection period by dividing your accounts receivable balance by your net credit sales and multiplying that figure by 365. This will give you the annual average collection period.
How Does the Average Collection Period Work?
Your average collection period will depend on the type of business you run. Some types of businesses expect payment sooner than others. Regardless of what's normal in your industry, knowing the average collection period will help you understand the liquidity of your firm.
The average collection period also reveals information about the company's credit policies. The business owner can evaluate how well the company's credit policy is working by evaluating the average collection period. If the average collection period isn't providing the liquidity the business needs, it may need to revisit its credit policy and create stricter requirements.
Choosing a Timeframe
The most common timeframe for this type of measurement is a year. That's where the 365 comes from in the equation above. However, analysts and business owners can use any other timeframe, if they would like to learn about a different period. They can replace the 365 in the equation with the number of days they wish to measure.
If an analyst does this, they must ensure that they aren't using annual data for the other figures. For example, a measurement of a monthly period should only account for the accounts receivable balance and net credit sales in that month being measured.
Accounts Receivable Balance
The average accounts receivable over the period can be determined by adding together the accounts receivable at the beginning of the period and the accounts receivable at the end of the period, then dividing by two.
Most businesses regularly account for accounts receivable outstanding—sometimes as often as on a weekly basis. For longer calculation periods, the beginning and ending figures for accounts receivable can be found in income statements or by adding the monthly accounts receivable figures found on the balance sheet.
Net Credit Sales
Net credit sales are simply the total of all credit sales minus total returns for the period in question. In most cases, this net credit sales figure is also available from the company's balance sheet.
Consider this example. A firm has accounts receivable on its balance sheet totaling $8,960. The income statement shows that credit sales were $215,600. You can use that information to calculate the average collection period.
- (Accounts receivable balance ÷ net credit sales) x 365 = average collection period
- (8,960 ÷ 215,600) x 365 = average collection period
- 0.0416 x 365 = average collection period
- 15.17 = average collection period
On average, in this example, customers pay their credit accounts every 15 days—every 15.17 days to be more exact. The business might then compare this figure to previous figures to provide greater context. If, in the year before, the business's average collection period was 20 days, then that means that the average collection period was reduced by roughly five days year-over-year. That's good news for the business—it's getting paid quicker, which should provide it with greater liquidity.
If a business's liquidity is decreasing, it may check the average collection period to see if that's the reason behind the declining liquidity. If a business's average collection period is improving, but its liquidity is getting worse, then that means the business is having issues in other aspects of its business. In this case, revisiting its credit policies won't help liquidity.
- The average collection period is the average amount of time it takes a business to receive payment for accounts receivable.
- The average collection period is primarily a measure of liquidity—it measures how quickly a business can turn sales into cash.
- If a business wants to improve its average collection period, it can change its credit policy to require quicker payments.