What Is the Average Collection Period Ratio?
The average collection period ratio, often shortened to "average collection period" is also referred to as the "ratio of days to sales outstanding." It is the average number of days it takes a company to collect its accounts receivable. In other words, this financial ratio is the average number of days required to convert receivables into cash. The mathematical formula to determine average collection ratio is simple but requires collecting some financial information first.
Average Collection Period Ratio Calculation
The formula for calculating the average collection period ratio is:
Days in Period x Average Accounts Receivable ÷ Net Credit Sales = Days to Collection
When using this average collection period ratio formula, the number of days can be a year (365) or a nominal accounting year (360) or any other period, so long as the other data -- average accounts receivable and net credit sales -- span the same number of days.
The average accounts receivable over the period can be determined by totaling the accounts receivable at the beginning of the period and the accounts receivable at the end of the period, then dividing by 2. Most businesses regularly account for the accounts receivable outstanding, sometimes weekly and often monthly. For longer calculation periods, the beginning and ending figures for accounts receivable can be found in the company's income statements or by adding the monthly accounts receivable figures for the year, which can be found on the balance sheet.
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.
The result of the calculation is the average number of days between the time a credit sale is initiated until the credit balance is paid.
A Working Example of the Calculation
For example, let's say that at the beginning of its 2016 fiscal year, Company, Inc. had accounts receivable outstanding of $46,000. At the end of the same year, its accounts receivable outstanding equaled $56,000. Over the same period, its net credit sales -- gross sales minus returns -- totaled $600,000.
- Adding beginning accounts receivable of 46,000 and ending accounts receivable of 56,000 totals 102,000. Dividing by 2 equals 51,000, which is the average accounts receivable outstanding during the one-year accounting period.
- Multiplying the average accounts receivable (51,000) by 365 days equals 18,615,000
- Dividing 18,615,000 by net sales of 600,000 equals 31.025 days, which is the average number of days from the date of a credit sale until the outstanding balance is collected.
The Significance of the Average Collection Period Ratio
Knowing your company's average collection period ratio figure gives you more than one valuable insight into your business. Nevertheless, it should be interpreted with some caution.
For one thing, to be meaningful the ratio needs to be interpreted comparatively. In comparison with previous years, is the business's ability to collect its receivables increasing -- the days-to-collection figure is trending down -- or is it increasing? If it's the latter, it means your accounts receivable are losing liquidity and you may need to take positive steps to reverse this trend.
You should also compare your company's credit policy with the average days from credit sale to balance collection to judge how well your firm is doing. If the average collection period, for example, is 45 days, but the firm's credit policy is to collect its receivables in 30 days, that's a problem. But if the average collection period is 45 days and the announced credit policy is net 10 days, that's significantly worse; your customers are very far from abiding by the credit agreement terms and this calls for a look at your firm's credit policy and instituting measures to change the situation, among them:
- Tightening credit requirements
- Making the credit terms clearer to your customers
- Instituting a discount period after which time amounts outstanding are due at net, such 2/10/net 30, which is a 2 percent discount if paid in ten days, with the full balance due in 30 days
- Instituting better follow-up on delinquent accounts
- Charging allowable interest on past due accounts