What Is the Average Collection Period?
The average collection period is the amount of time it takes for a company to receive payments owed by its customers in phrases of accounts receivable (AR).
Businesses compute the average collection period to make sure they have enough cash on hand to meet their financial debts.
The average collection period is computed by dividing the average balance of accounts receivable by total net credit sales for the period and multiplying the quotient by the number of days in the period.
Average collection periods are most crucial for businesses that depend heavily on receivables for their cash flows.
Realizing the Average Collection Period
The average collection period exemplifies the average number of days between the date a credit sale is created and the date the purchaser pays for that sale.
An organization's average collection period is indicative of the effectiveness of its accounts receivable management methods. Companies must be eligible to organize their average collection period to guarantee they operate smoothly.
A shorter average collection period is commonly more favourable than a longer average collection period. A short average collection period reflects the company collects payments quickly.
There is a downside to this, though, as it may demonstrate its credit terms are too strict. Buyers may investigate suppliers or service providers with extra lenient payment duration.
The average balance of accounts receivable is calculated by adding the opening balance in accounts receivable (AR) and ending the balance in accounts receivable and dividing that total by two. When computing the average collection period for an entire year, 360 may be used as the number of days in one year for simplicity.
Average Collection Period
Illustration of an Average Collection Period
Let's say a business has an average accounts receivable balance for the year of $20,000.
The total net sales the company recorded during this period was $200,000. So to calculate the average collection period, we use the following formula:
(($20,000 ÷ $200,000) x 360).
The average collection period, accordingly, would be 36 days—not a horrible sign, assuming most businesses collect within 30 days. Collecting its receivables in a somewhat short—and reasonable—period provides the business time to pay off its debts.
If this business's average collection period was longer—say more than 60 days, it would need to accept an extra less aggressive collection agreement to reduce that time structure.
Accounts Receivable Turnover.
The average collection period is almost associated with the accounts turnover ratio.
The accounts turnover ratio is calculated by dividing total net sales by the average accounts receivable balance.
In the previous illustration, the accounts receivable turnover is 10 ($200,000 ÷ $20,000).
The average collection period can be computed using the accounts receivable turnover by dividing the number of days in the period by the metric. In this illustration, the average collection period is the same as before at 36 days (360 days ÷ 10).
Comparability.
The average collection period does not hold much value as a standalone picture. Rather, you can get more out of its usefulness by using it as a comparative means.
The reasonable manner a business can assist is by always computing its average collection period, and using this figure overtime to search for directions within its own business.
The average collection period may furthermore be used to compare one firm with its competitors, either separately or grouped. Identical businesses should generate identical financial metrics, so the average collection period can be used as a benchmark against another company's achievement.
Businesses may moreover compare the average collection period to the credit terms expanded to buyers. For instance, an average collection period of 25 days isn't as concerning if invoices are issued with a net 30 due date. But, a continuous examination of the outstanding collection period immediately influences the organization's cash flows.
Collections by Enterprises.
Not all businesses deal with credit and cash, or receivables in the exact path. Although cash on hand is significant to every company, some rely further on their cash flow than others.
For instance, the banking district depends heavily on receivables because of the loans and mortgages it offers to customers.
Since it depends on income produced from these products, banks must have a short turnaround time for receivables. If they have flexible collection techniques and agreements in place, income would drop, implying financial destruction.
Real estate and construction corporations also rely on constant cash flows to pay for labour, services, and supplies.
These industries don't certainly generate income as readily as banks, so it's valuable that those working in these industries bill at reasonable periods as sales and construction take time, and may be subject to delays.
Why Is the Average Collection Period Important?
The average collection period is indicative of the power of a company's accounts receivable management strategies and is most significant for businesses that depend heavily on receivables for their cash flows. Businesses must be eligible to manage their average collection period to ensure that they have sufficient cash on hand to satisfy their financial duties.
How Is Average Collection Period Calculated?
The average collection period is calculated by dividing the average balance of accounts receivable by total net credit sales for the period and multiplying the quotient by the number of days in the period. So, if a business has an average accounts receivable balance for the year of 20,000 and total net sales of $200,000 then the average collection period would be (($20,000 ÷ $200,000) x 360), or 36 days.
Why Is a Lower Average Collection Period Better?
A shorter average collection period is normally more favourable than a longer average collection period as it demonstrates the company is more efficient in collecting payments.
Nonetheless, there is a downside to this as it may imply its credit terms are too strict which could result in it forfeiting buyers to competitors with more relaxed payment terms.
Summary
• The average collection time is the amount of time it takes for a business to receive payments owed by its clients.
• Businesses calculate the average collection period to guarantee they have enough cash on hand to fulfil their financial duties.
• Short average collection periods reflects companies collect payments quickly.
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