Average Collection Period: Understanding Its Importance in Business Finance

However, if the company knows a large account receivable is about to be paid, this might be reasonable. On the other hand, a short average collection period indicates that a company is strict or quick in its collection practices. While this might seem beneficial at first glance, as it provides the opportunity for quick cash turnover and reinvestment, there can also be potential pitfalls. On the other hand, the DSO ratio estimates how long it takes a company to collect payments after a sale has been made. The ratio is interpreted/counted in days and can be computed by multiplying the ACP by the number of days in a given period. If a company has a longer average collection period, it means its cash inflow is slower, potentially leading to cash crunches, especially for small and medium-sized businesses.

This is especially common when a small business wants to sell to a large retail chain, which can promise a large sales boost in exchange for long payment terms. In short, looser credit can be a tactical step to increase sales, or is a response to pressure from important customers. The measure is best examined on a trend line, to see if there are any long-term changes. In a business where sales are steady and the customer mix is unchanging, the average collection period should be quite consistent from period to period. Conversely, when sales and/or the mix of customers is changing dramatically, this measure can be expected to vary substantially over time.

What Is Average Collection Period Ratio Formula and How to Calculate It

This strategy can reduce the average collection period, but it may also reduce the total amount you collect, so it’s vital to consider the overall impact on profitability. Lastly, offering incentives for prompt payments could motivate your clients to pay their bills faster, thus decreasing the average collection period. A longer collection period might indicate financial distress, as it could mean customers are struggling to pay their bills, or the company is not enforcing its collection terms strictly enough.

Once you have the required information, you can use our built-in calculator or the formula given below to understand how to find the average collection period. All these strategies, while having their distinct benefits, require careful consideration of their implications and must be implemented thoughtfully to optimize the average collection period effectively. From a timing perspective, looking at the average collection period can help a company to schedule potential expenditures and prepare a reasonable plan for covering these costs. The owner of this website may be compensated in exchange for featured placement of certain sponsored products and services, or your clicking on links posted on this website. This compensation may impact how and where products appear on this site (including, for example, the order in which they appear), with exception for mortgage and home lending related products.

What Is an Average Collection Period?

Annabel, the company’s accountant, wants to calculate the average period and determine if there should be any adjustments in the company’s credit policies. The receivables turnover can use the total accounts receivable at the end of a period or the average throughout the period. Investors and analysts may not have access to the average receivables so they would need to use the ending balance or an average of four quarters for a full year. Also, this metric is an average across a specified number of days, so it is not an exact measure and will be more broadly skewed with the number of days involved.

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• This will shorten the average collection period, but will also likely reduce sales, as some customers take their business elsewhere.
• To calculate the average collection period formula, we simply divide accounts receivable by credit sales times 365 days.
• A fast collection period may not always be beneficial as it simply could mean that the company has strict payment rules in place.
• Net credit sales are the total of all credit sales minus total returns for the period in question.

A fast collection period may not always be beneficial as it simply could mean that the company has strict payment rules in place. 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. If they have lax collection procedures and policies in place, then income would drop, causing financial harm. Although cash on hand is important to every business, some rely more on their cash flow than others. The average collection period is often not an externally required figure to be reported.

What Is a Good Average Collection Period Ratio?

Finding a middle ground between short and long collection periods will allow a company or organization to reap the benefits of a consistent cash flow, without alienating clients and customers. 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. Efficient and ethical management of the average collection period signals a corporation’s alignment with socially responsible financial practices. The average collection period focuses on the time it takes a company to receive payments due from its customers.

This includes any discounts awarded to customers, product recalls or returns, or items re-issued under warranty. Every business has its average collection period standards, mainly based on its credit terms. In the following scenarios, you can see how the average collection period affects cash flow. The result above shows that your average collection period is approximately 91 days.

It is a reflection of how quickly a business collects its receivables, and therefore, how efficiently its operations are managed. A shorter collection period indicates that a company collects money from its customers promptly, average collection period meaning suggesting efficient credit and collections departments. Through this formula, we can see the relationship between the volume of accounts receivables, the average daily sales, and the time frame (measured usually in days).