What Is the Average Collection Period Ratio?
How to Calculate the Average Collection Period Ratio
The average collection period ratio is the average number of days it takes a company to collect its accounts receivable.
Learn more about what it is, how to calculate it, and how it works.
What Is the Average Collection Period Ratio?
This financial ratio calculates the average amount of time it takes for clients to pay their bills to you, or the average number of days between the time a credit sale is initiated until the credit balance is paid. It indicates the average number of days required to convert receivables into cash.
The average collection period ratio is often shortened to "average collection period" and can also be referred to as the "ratio of days to sales outstanding."
Average Collection Period Ratio Calculation
The mathematical formula to determine average collection ratio requires you to multiply the days in the period by the average accounts receivable in that period and divide the result by net credit sales during the period.
The formula for calculating the average collection period ratio is:
You can calculate the average accounts receivable over the period by totaling the accounts receivable at the beginning of the period and the end of the period, then divide that by 2.
Most businesses regularly account for their 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 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.
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.
How the Average Collection Period Ratio Works
Knowing your company's average collection period ratio can help you determine how effective its credit and collection policies are.
If your company requires invoices to be paid within 30 days, then a lower average than 30 would mean that you collect accounts efficiently. An average higher than 30 can mean that you're having trouble collecting your accounts, and it could also indicate trouble with cash flow.
Let's say that at the beginning of a fiscal year, company ABC had accounts receivable outstanding of $46,000. At the end of the same year, its accounts receivable outstanding was $56,000. That means the average accounts receivable for the period came to $51,000 ($102,000 / 2).
Over the same 365-day period, its net credit sales—gross sales minus returns—totaled $600,000.
So company ABC's average collection period ratio, or the average number of days from the date of a credit sale until the outstanding balance is collected, is 31.025: (51,000 x 365) / 600,000.
Limitations of the Average Collection Period Ratio
It's wise to interpret the average collection period ratio 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 average collection period ratio is lower) or decreasing (the average collection period ratio is higher). If it's decreasing in comparison then 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. This calls for a look at your firm's credit policy and instituting measures to change the situation, including tightening credit requirements or making the credit terms clearer to your customers.
- Knowing a company's average collection period ratio can help determine how effective its credit and collection policies are.
- The average collection period ratio calculates the average amount of time it takes for a company to collect its accounts receivable, or for its clients to pay.
- It can be calculated by multiplying the days in the period by the average accounts receivable in that period and dividing the result by net credit sales during the period.
- The result should be interpreted by comparing it to a company's past ratios, as well as its payment policy.