What Is Average Collection Period? – Formula and How to Calculate It

Introduction

In today’s business landscape, it’s common for most organizations to offer credit to their customers. After all, very few companies can rely solely on cash transactions for all their sales. If your business follows suit by extending credit to customers, it becomes crucial to efficiently manage payment collections.

The average collection period emerges as a valuable metric to help in this endeavor. It stands as an essential financial metric that grants businesses insight into the speed at which they can convert credit sales into actual cash.

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.

What Is Average Collection Period?

The average collection period is the time it takes for a business to collect payments from its customers after a sale has been made. It measures how long it takes for invoices to be paid on average. A shorter collection period means customers pay faster, which improves cash flow.For example, if a company has an average collection period of 30 days, it means they typically receive payments 30 days after issuing an invoice. Businesses aim for a lower average collection period to ensure they have enough cash to cover their expenses.

How to Calculate Average Collection Period?

The average collection period is calculated by dividing the net credit sales by the average accounts receivable, which gives the Accounts receivable turnover ratio. To determine the average collection period, divide 365 days by the accounts receivable turnover ratio.

Step 1: Understand the Receivables Turnover Ratio

The Receivables Turnover Ratio measures how many times a company collects its average accounts receivable during a period, usually a year. It’s calculated using the formula:

• • Net Credit Sales: The total sales made on credit during a specific period, excluding cash sales.
  • Average Accounts Receivable: The average amount of money owed by customers, typically calculated as:

Step 2: Calculate the Receivables Turnover Ratio

First, gather the net credit sales and average accounts receivable for the period. Then, use the formula above to calculate the receivables turnover ratio.

Example:

Let’s say a company has:

• Net Credit Sales = $500,000
• Beginning Accounts Receivable = $40,000
• Ending Accounts Receivable = $60,000

First, calculate the average accounts receivable:Average Accounts Receivable = (40,000+60,000) ÷ 2 = 50,000Now, calculate the receivables turnover ratio:Receivables Turnover Ratio = 500,000 ÷ 50,000 =10

Step 3: Calculate the Average Collection Period

Now that we have the receivables turnover ratio use the formula to find the average collection period:Average Collection Period = 365 ÷ 10 = 36.5 daysThis means the company, on average, takes 36.5 days to collect payments from its customers. The lower the average collection period, the faster a company is collecting payments.

Related Read: Days Sales Outstanding: What Is It & How It Can Optimize Your A/R

Real-life Example of How to Calculate Average Collection Period Ratio

Let’s understand average collection period with an example:

Say, your company generated $150,000 through credit sales over a year. At the beginning of the year, your accounts receivable were at $5,000, which increased to $10,000 by year-end.

By using the formula, we calculate the Account Receivable Turnover Ratio as follows:

Net Credit Sales = $150,000 Average Accounts Receivables = ($5,000 + $10,000) / 2 = $7,500

Account Receivable Turnover Ratio = (Net Credit Sales / Average Accounts Receivables) = ($150,000 / $7,500) = 20 times

Now, translating this into practical terms for you: Average Collection Period = (365 / Account Receivable Turnover Ratio) = (365 / 20) = 18.25 days.

This means that, on average, it takes around 18.25 days for your company to collect payments from customers after a credit sale. This metric helps you gauge how effectively you’re converting credit sales into actual cash flow

How to Interpret the Average Collection Period?

A high collection period often signals that a company is experiencing delays in receiving payments. However, it’s important not to draw immediate conclusions from this metric alone.

Let’s consider an example to highlight this: imagine a company with an ACP of 50 days, issuing invoices due in 60 days – here, the ACP appears reasonable. Yet, if the same company sets a due date of 30 days, the ACP would seem notably higher. This illustrates how the interpretation of the average collection period depends on payment terms and practices.

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.

This comparison includes the industry’s standard for the average collection period and the company’s historical performance.

By benchmarking against the industry standard, a company can gauge easily whether the number is acceptable or if there is potential for improvement.

How to Monitor the Average Collection Period

Monitoring the average collection period (ACP) is important for understanding how efficiently a business is collecting payments from customers. Here’s how you can effectively monitor it:

1. Regularly Calculate ACP

• Calculate the ACP on a regular basis (monthly, quarterly, or annually) using the formula:

ACP = 365 ÷ Receivables Turnover RatioOr alternatively:ACP = Average Accounts Receivable ÷ Net Credit Sales × 365This helps track changes over time and indicates whether your collections process is improving or deteriorating.

2. Set Benchmarks and Compare

• Set internal benchmarks based on industry standards or historical data.
• Compare your ACP to these benchmarks to see how well your company is doing compared to industry norms or past performance. If the ACP is increasing, it means your customers are taking longer to pay, which could affect your cash flow.

3. Use Accounting Software

• Most accounting software and ERP systems can automatically track and calculate key metrics, including ACP.
• Set up dashboards that monitor your average collection period in real-time, making it easier to spot trends.

4. Analyze Payment Terms and Policies

• Compare the ACP with the payment terms you provide to customers. For example, if your payment terms are 30 days but your ACP is 45 days, there might be an issue with collections.
• Adjust credit policies or terms based on trends to reduce the ACP.

5. Monitor Receivables Aging Report

• Regularly review aging reports, which show outstanding invoices and their due dates.
• Aging reports help identify overdue accounts and focus your efforts on collecting those, reducing the overall ACP.

6. Track Payment Patterns

• Monitor customer payment behavior and look for patterns.
• Identify customers who frequently delay payments and consider adjusting credit terms for them or offering early payment incentives to reduce delays.

7. Set Alerts for Long ACP

• Set up automated alerts or flags in your system for when the ACP exceeds a certain threshold.
• This enables your finance or collections team to act quickly if payments are being delayed longer than expected.

8. Communicate with the Collections Team

• Regular communication with your collections team is crucial. They should be aware of ACP targets and take necessary actions like sending reminders, contacting overdue customers, or adjusting collection strategies.

By regularly calculating the average collection period, leveraging technology, and closely monitoring customer payment behavior, you can monitor your company’s cash flow and take proactive steps to improve collections.

Why Is It Critical to Track the Average Collection Period?

A company’s average collection period gives an insight into its AR health, credit terms, and cash flow. Without tracking the ACP, it will become difficult for businesses to plan for future expenses and projects. Here are two important reasons why every business needs to keep an eye on their average collection period.

1. Strategic cash flow projection: The ACP offers a clear window into a company’s collections landscape. By forecasting cash flow from accounts receivable, businesses can proactively plan expenses. For instance, if the ACP is 25 days and outstanding receivables amount to $500,000 with a 20-day maturity, companies can expect receipt within about a week.
2. Evaluating Credit Terms: ACP plays a vital role in credit terms assessment. While a lower number is generally favorable,comparing it with other companies in your industry is essential. Deviations can indicate excessively stringent credit terms.. For instance, if a company’s ACP is 15 days while the industry average is approximately 30 days, it could impede customer acquisition. Striking the appropriate balance is of paramount importance.

How HighRadius Can Help

According to a PYMNTS report, 88% of businesses automating their AR processes see a significant reduction in their DSO. Automation can also help reduce manual intervention in collection processes, enabling proactive communication with customers and helping establish appropriate credit limits.

HighRadius offers a comprehensive, cloud-based solution to automate and streamline the Order to Cash (O2C) process for businesses. Our solution aims to boost the efficiency of your team with our end-to-end solution, including Collections Management, Cash Application, Deductions Management, Electronic Invoicing, Payment Gateway, Surcharge Management, Interchange Fee Optimizer, Credit Cloud, & dotOne Analytics.

Trusted by 1000+ companies to deliver speed-to-value, including P&G, Ferrero, Johnson & Johnson, and Danone,  HighRadius has been a Gartner Magic Quadrant Leader 3 years in a row, placed highest in the ability to execute and furthest in the completeness of vision.

FreedaGPT, a Gen AI assistant integrated with LiveCube, a spreadsheet-like tool, helps manage data, analyze information, and generate insightful reports—all using simple, plain English commands.

HighRadius’ AI-powered collections software helps prioritize worklists for the top 20% of customers and automates collections for 80% of long-tail customers. This results in a 20% reduction in past-due accounts and a 30% increase in collector productivity.

FAQs

1. What is a good average collection period?
   There isn’t one right or good number – it varies, but a shorter period often shows that a business is efficiently turning credit sales into cash and managing cash flow well.
   
2. What does a longer collection period mean? 
   A longer average collection period suggests delays in receiving payments, potentially signaling issues with accounts receivable management and cash flow.
   
3. How can I improve my collection period?
   You can improve your collection period by implementing efficient credit policies, offering incentives for early payments, automating collection processes, and maintaining effective communication with customers.
   
4. What does the average collection period tell?
   The average collection period assists in evaluating a company’s financial well-being, credit strategies, and cash flow. Comparing it with industry norms and historical data enhances its value as a metric.