Average Collection Period: Understanding Its Importance in Business Finance

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Consequentially, it may result in slower growth and potentially missed market opportunities. So, when a company’s average collection period is lengthy, it means its accounts receivable aren’t being converted into cash quickly. In other words, its current assets are reducing, subsequently shrinking its working capital. With less working capital, a company may struggle to https://turbo-tax.org/ pay off its short-term liabilities, thus putting pressure on its liquidity. Therefore, understanding each component and how they interact can provide insightful information regarding the financial health of a business. It can help identify potential problems in the company’s credit policies if, for instance, the average collection period is trending upward over time.

This may also include limiting the number of clients it offers credit to in an effort to increase cash sales. It can also offer pricing discounts for earlier payment (i.e. 2% discount if paid in 10 days). 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 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.

  1. Conversely, when sales and/or the mix of customers is changing dramatically, this measure can be expected to vary substantially over time.
  2. Furthermore, a lengthier collection period reduces the availability of cash for investment opportunities, whether that’s expansion, R&D, or strategic moves to outperform competitors.
  3. In essence, the smoother the inflow of cash, the more smooth-running the company’s operations will likely be.
  4. The average collection period figure allows a company to plan effectively for forthcoming costs.
  5. Alternatively and more commonly, the average collection period is denoted as the number of days of a period divided by the receivables turnover ratio.

It’s essential to understand these dynamics when analyzing a company’s average collection period, comparative to its industry peers. The average collection period’s impact extends to the overall stability and growth of a business. Ideally, a company strives to maintain a balance where it can collect its receivables quickly and defer its payables for as long as possible. The company may struggle to meet its financial obligations, potentially affecting its creditworthiness and ability to attract further investment. By the same token, the average collection period also provides insights into the effectiveness of the collections department. A longer collection period might indicate lax collection efforts, inefficient collections procedures, or poorly trained staff.

The terms of credit extended to customers also play an integral part in determining the collection period. A business that offers extensive credit terms, such as ‘net 90 days’, will naturally have a longer average collection period than a business that insists on ‘net 30 days’. Industries that serve big businesses or government agencies may offer these longer terms as a competitive advantage, pushing out their collection periods. Accrual accounting is a business standard under generally accepted accounting principles (GAAP) that makes it possible for companies to sell their goods and services with credit. While it is expected to help increase sales for a firm, it’s a concept that creates a core element of complexity for financial statement reporting. As a result, keeping cash in hand has proven critical for smaller enterprises, as it allows them to pay off future debt and other financial obligations.

We’ll show you how to analyse your average collection period a little later on in this post. GoCardless helps you automate payment collection, cutting down on the amount of admin your team needs to deal with when chasing invoices. 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. In the following example of the average collection period calculation, we’ll use two different methods. It’s easy to think that the only thing that matters about invoices is that they get paid, but actually, the time required for each invoice to be fulfilled is also crucial.

How Is the Average Collection Period Calculated?

This is entirely an internal issue for which management is responsible, and so can be corrected through management action. An increase in the average collection period can be indicative of any of the conditions noted below, relating to looser credit policy, a worsening economy, and reduced collection average collection period formula efforts. 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.

Example of the average collection period

In some cases, this may be out of your control, such as a downturn in the economy which means everyone is struggling to find the funds needed to pay their bills. Alternatively, the issue may be entirely within your control, such as a finance team that isn’t prioritizing incoming payments, whether that means issuing an invoice or chasing them up. Integrating best practices into the collections department and team can help to improve collection efficiency.

If the company is unable to continuously invest the collected funds efficiently, this surplus cash simply sitting idle could represent a cost. As money loses value over time due to inflation, the idle cash might steadily lose its purchasing power. On the reputational front, consistently slow receivable collection may signal financial instability or poor credit management to stakeholders, including investors, lenders, and credit rating agencies. This could potentially result in more restrictive credit terms from suppliers, higher interest rates on loans, and a lower credit rating, further impacting the financial position of the company.

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

A few other KPIs that a company needs to compare it with, to get a clear picture of what the ACP indicates. These include the industry standard of the average collections period and the company’s past performance. If a company’s ACP is 15 days, but the industry standard is close to 30 days, it could be because the credit terms are too strict. In such cases, a business may lose out on potential customers to competitors with better credit policies. A company’s commitment to effective collection period management also contributes to overall economic stability. By ensuring their average collection period aligns with what’s reasonably expected within their sector, businesses can avoid contributing to cash flow problems and subsequent financial pressures.

These issues have pushed businesses to further streamline their accounts receivable process by implementing several key metrics and procedures to maintain liquidity. This should be fair and accommodating to customers while efficient and realistic to the firm. Without this, predicting future cash flows, demand, and liquidity of the business will be tough; therefore, planning expenses and investments will be a relatively complex task. When businesses rely on a few large customers, they take on the risk of a delay in payment. This can lead to financial difficulties and closing down their business in the worst case. Our model unveils the dynamics, depicting that the cost of collections is just a few cents within the credit period.

Too long an ACP may indicate inefficiencies in collecting debts from customers, which could be dangerous as it may lead to a cash crunch. Conversely, a too short ACP can suggest overly aggressive collection tactics, which might strain customer relationships. Moreover, the inability to generate cash quickly can hinder a company’s growth ambitions. Expansion initiatives often require a sufficient cash reserve for new investments and to protect against any revenue shortfalls during the growth phase. With money tied up in accounts receivable due to a longer average collection period, businesses might find it hard to pursue these initiatives.

Impact on Cash Flow and Liquidity

By benchmarking against the industry standard, a company can gauge easily whether the number is acceptable or if there is potential for improvement. We’ll use the ending A/R balance for our calculations here and assume the number of days in the period is 365 days. Over 1.8 million professionals use CFI to learn accounting, financial analysis, modeling and more.

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. It enables the company to maintain a level of liquidity, which allows it to pay for immediate expenses and to get a general idea of when it may be capable of making larger purchases. Calculating the average collection period for any company is important because it helps the company better understand how efficiently it’s collecting the money it needs to cover its expenditures. Days payable outstanding is a ratio used to figure out how long it takes a company, on average, to pay its bills and invoices.

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