Average Collection Period Formula, How It Works, Example

A high accounts receivable turnover also indicates that the company enjoys a high-quality customer base that is able to pay their debts quickly. Also, a high ratio can suggest that the company follows a conservative credit policy such as net-20-days or even a net-10-days policy. One of the simplest ways to calculate the average collection period is to start with receivables turnover which is calculated by dividing sales over accounts receivable to determine the turnover ratio. The numerator of the accounts receivable turnover ratio is net credit sales, the amount of revenue earned by a company paid via credit.

If the accounts receivable collection period is more extended than expected, this could indicate that customers don’t pay on time. It’s a good idea to review your balance sheet and credit terms to improve collection efforts. The receivables turnover can use the total accounts receivable at the end of a period or the average throughout the period.

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. Some companies use total sales instead of net sales when calculating their turnover ratio.

It makes sense that businesses want to reduce the time it takes to collect payment from a credit sale. Prompt, complete payment translates to more cash flow available and fewer clients you must remind to pay every month. You can understand https://1investing.in/ how much cash flow is pending or readily available by monitoring your average collection period. Measuring this performance metric also provides insights into how efficiently your accounts receivable department is operating.

As such, they indicate their ability to pay off their short-term debts without the need to rely on additional cash flows. Review your payment terms from time to time to ensure they are still appropriate for your business needs. The accounts receivable turnover ratio tells a company how efficiently its collection process is. This is important because it directly correlates to how much cash a company may have on hand in addition to how much cash it may expect to receive in the short-term.

That’s because companies of different sizes often have very different capital structures, which can greatly influence turnover calculations, and the same is often true of companies in different industries. Accounts receivables appear under the current assets section of a company’s balance sheet. In 2020, the company’s ending accounts receivable (A/R) balance was $20k, which grew to $24k in the subsequent year. However, using the average balance creates the need for more historical reference data. If the average A/R balances were used instead, we would require more historical data.

It’s not enough to look at a final balance sheet and guess which areas need improvement. You must monitor and evaluate important A/R key performance metrics in order to improve performance and efficiency. Let’s say that at the beginning of a fiscal year, company ABC had accounts receivable outstanding of $46,000.

  1. The receivables turnover can use the total accounts receivable at the end of a period or the average throughout the period.
  2. Therefore, the average customer takes approximately 51 days to pay their debt to the store.
  3. More sophisticated accounting reporting tools may be able to automate a company’s average accounts receivable over a given period by factoring in daily ending balances.
  4. Average collection period boils down to a single number; however, it has many different uses and communicates a variety of important information.
  5. A low average collection period figure doesn’t always indicate increased total net sales, especially if credit sale numbers are low.

When evaluating an externally-calculated ratio, ensure you understand how the ratio was calculated. A low average collection period indicates that the organization collects payments faster. Customers who don’t find their creditors’ terms very friendly may choose to seek suppliers or service providers with more lenient payment terms. Make sure the same period is being used for both net credit sales and average debtors collection period formula receivables by pulling the numbers from the same balance sheets. Knowing the accounts receivable collection period helps businesses make more accurate projections of when money will be received. We hope you now have a thorough understanding of what the average collection period is and how to find an average collection period to offer credit terms that are best suited for both your business and your clients.

What Is a Good Accounts Receivable Turnover Ratio?

Companies use the average collection period to make sure they have enough cash on hand to meet their financial obligations. The average collection period is an indicator of the effectiveness of a firm’s AR management practices and is an important metric for companies that rely heavily on receivables for their cash flows. Additionally, a low ratio can indicate that the company is extending its credit policy for too long. It can sometimes be seen in earnings management, where managers offer a very long credit policy to generate additional sales. Due to the time value of money principle, the longer a company takes to collect on its credit sales, the more money a company effectively loses, or the less valuable are the company’s sales. Therefore, a low or declining accounts receivable turnover ratio is considered detrimental to a company.

Interpretation of Accounts Receivable Turnover Ratio

Upon dividing the receivables turnover ratio by 365, we arrive at the same implied collection periods for both 2020 and 2021 — confirming our prior calculations were correct. Since the collection period refers to the number of days it takes a company on average to collect cash from credit purchases, companies strive to reduce the time needed as they mature to increase their near-term liquidity. Therefore, the average customer takes approximately 51 days to pay their debt to the store. If Trinity Bikes Shop maintains a policy for payments made on credit, such as a 30-day policy, the receivable turnover in days calculated above would indicate that the average customer makes late payments. A long debtors collection period is an indication of slow or late payments by debtors.

This allows for a company to have more cash quicker to strategically deploy for the use of its operations or growth. For example, if the company’s distribution division is operating poorly, it might be failing to deliver the correct goods to customers in a timely manner. As a result, customers might delay paying their receivables, which would decrease the company’s receivables turnover ratio.

Oftentimes, companies will also consider accounts receivable write-offs in conjunction with average collection period days for a broader assessment. Creditors may also follow average collection period data and may even include threshold requirements for maintaining credit terms. This type of evaluation, in business accounting, is known as accounts receivables turnover. You can calculate it by dividing your net credit sales and the average accounts receivable balance. Alternatively, check the receivables turnover ratio calculator, which may help you understand this metric. Average collection period refers to the amount of time it takes for a business to receive payments owed by its clients in terms of accounts receivable (AR).

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While a shorter average collection period is often better, too strict of credit terms may scare customers away. The average collection period is closely related to the accounts turnover ratio, which is calculated by dividing total net sales by the average AR balance. 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.

Net income and sales operate on a delayed schedule, and companies crunch the numbers expecting to settle invoices and get paid sometime in the future. In addition to being limited to only credit sales, net credit sales exclude residual transactions that impact and often reduce sales amounts. This includes any discounts awarded to customers, product recalls or returns, or items re-issued under warranty.

The receivables turnover estimates the number of times that a company collects owed cash payments from customers per year, and is calculated as the ratio between the company’s credit sales and its average A/R balance. The accounts receivable turnover ratio is an efficiency ratio and is an indicator of a company’s financial and operational performance. A high ratio is desirable, as it indicates that the company’s collection of accounts receivable is frequent and efficient.

Suppose a company generated $280k and $360k in net credit sales for the fiscal years ending 2020 and 2021, respectively. Over 1.8 million professionals use CFI to learn accounting, financial analysis, modeling and more. Start with a free account to explore 20+ always-free courses and hundreds of finance templates and cheat sheets. For example, the banking sector relies heavily on receivables because of the loans and mortgages that it offers to consumers. As it relies on income generated from these products, banks must have a short turnaround time for receivables.

This metric should exclude cash sales (as those are not made on credit and therefore do not have a collection period). For the formulas above, average accounts receivable is calculated by taking the average of the beginning and ending balances of a given period. More sophisticated accounting reporting tools may be able to automate a company’s average accounts receivable over a given period by factoring in daily ending balances.

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