The normal amount of time that passes before a company collects its accounts receivables
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The average collection period amount of time that passes before a company collects its accounts receivable (AR). In other words, it refers to the time it takes, on average, for the company to receive payments it is owed from clients or customers. The average collection period must be monitored to ensure a company has enough cash available to take care of its near-term financial responsibilities.
To be clear, the average collection period – as the name indicates – is a calculation of the average number of days between the date a sale is made (on credit) and the date that the buyer submits the payment or the date that the company receives the payment from the buyer.
The average collection period is the length of time – on average – it takes a company to receive payments in the form of accounts receivable.
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.
The average collection period is calculated by dividing a company’s yearly accounts receivable balance by its yearly total net sales; this number is then multiplied by 365 to generate a number in days.
Importance of the Average Collection Period
1. Maintain liquidity
Clearly, it is crucial for a company to receive payment for goods or services rendered in a timely manner. 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.
2. Plan for future costs and schedule potential expenditures
The average collection period figure is also important from a timing perspective to help a company prepare an effective plan for covering costs and scheduling potential expenditures to further growth.
For obvious reasons, the smaller the average collection period is, the better it is for the company. It means that a company’s clients take less time to pay their bills. Another way to look at it is that a lower average collection period means the company collects payment faster.
A fast collection period may not always be beneficial as it simply could mean that the company has strict payment rules in place. The rules may work for some clients. However, stricter collection requirements can end up turning some customers away, sending them to look for companies with the same goods or services and more lenient payment rules or better payment options.
Average Collection Period Formula
Let’s talk about how a company calculates its average collection period. Generally, the average collection period is calculated in days. The company must calculate its average balance of accounts receivable for the year and divide it by total net sales for the year. The formula looks like the one below:
To better show the formula in action, consider the following example. Let’s say that Company ABC recorded a yearly accounts receivable balance of $25,000. In the same year, the company logged $200,000 in total net sales.
The first step to determining the company’s average collection period is to divide $25,000 by $200,000. The quotient, then, must be multiplied by 365 because the calculation is to determine the average collection period for the year. For our example, the average collection period calculation looks like the one below:
(25,000 / 200,000) x 365 = 45.6
It means that Company ABC’s average collection period for the year is about 46 days. It is slightly high when you consider that most companies try to collect payments within 30 days.
For the company, its average collection period figure can mean a few things. It may mean that the company isn’t as efficient as it needs to be when staying on top of collecting accounts receivable. However, the figure can also represent that the company offers more flexible payment terms when it comes to outstanding payments.
CFI offers the Commercial Banking & Credit Analyst (CBCA)™ certification program for those looking to take their careers to the next level. To keep learning and developing your knowledge base, please explore the additional relevant resources below:
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