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

Here, net credit sales come from the income statement, which covers a period of time. At the same time, the AR value can be found on the balance sheet, which provides a snapshot of a point in time. As such, it is acceptable to use the average balance of AR over the same period of time as covered in the income statement. Naturally, a smaller value of the average collection period ratio is considered more beneficial for a company. It indicates that a company’s clients pay their bills faster, or that the company collects payments faster. Calculating the average collection period with average accounts receivable and total credit sales.

Analyzing Credit Terms

Also, construction of buildings and real estate sales take time and can be subject to delays. So, in this line of work, it’s best to bill customers at suitable intervals while keeping an eye on average sales. For example, financial institutions, i.e., banks, rely on accounts receivable because they offer their customers credit loans, installments, and mortgages. A short and precise turnaround time is required to generate ROI from such services (you can find more about this metric in the ROI calculator).

It means that your clients take a shorter period of time to petty cash book: types diagrams and examples pay their bills and you have less uncertainty about payment times. Every business has its average collection period standards, mainly based on its credit terms. 🔎 You can also enter your terms of credit in our calculator to compare them with your average collection period.

1. The best average collection period is about balancing between your business’s credit terms and your accounts receivables.
2. For the formulas above, average accounts receivable is calculated by taking the average of the beginning and ending balances of a given period.
3. To find the average collection period of a company, you need to obtain its accounts receivable values from the balance sheet, along with its revenue for the same period.
4. This ratio measures the number of days it takes a company to convert its sales into cash.
5. Also, construction of buildings and real estate sales take time and can be subject to delays.
6. Let’s say that Company ABC recorded a yearly accounts receivable balance of $25,000.

Average Accounts Receivables

The average collection period, or ACP, refers to the amount of time it takes for a business to receive any payments that it is owed by its clients. In today’s business landscape, it’s common for most organizations to offer credit to their customers. Calculating the average collection period with accounts receivable turnover ratio. Once you have calculated your average collection period, you can compare it with the time frame given in your credit terms to understand your business needs better. This formula can also be calculated by using the accounts receivable turnover ratio. In the first formula, we first need to determine the accounts receivable turnover ratio.

More About Glossary of Common Financial Terms

A company’s average collection period gives an insight into its AR health, credit terms, and cash flow. Without tracking the ACP, it will become difficult for businesses to plan for future expenses and projects. Here are two important reasons why every business needs to keep an eye on their average collection period. It increases the cash inflow and proves the efficiency of company management in managing its clients. An organization that can collect payments faster or on time has strong collection practices and also has loyal customers.

How average collection period affects cash flow

The average collection period for a company helps it determine the time taken in days by a company to convert its trade receivables into cash. It determines a company’s debt collection soundness and helps it formulate and maintain a credit policy. A low number of average collection days is considered good because it implies that the company can quickly retrieve the funds from the trade receivables. Typically, lower collection periods are preferred, as the shorter duration indicates contingent liabilities more efficiency in credit collections. On the other hand, a high average collection period signals that a company might be taking too long to collect payments on their accounts receivables.

The average collection period is often not an externally required figure to be reported. The usefulness of average collection period is to inform management of its operations. 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. As you can see, it takes Devin approximately 31 days to collect cash from his customers on average. The ACP value could also decrease if a company has imposed shorter payment deadlines and tightened its credit policies.

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.

Our model unveils the dynamics, depicting that the cost of collections is just a few cents within the credit period. However, as invoices age past 90 days, this cost escalates significantly, reaching $10-$12. This comparison includes the industry’s standard for the average collection period and the company’s historical performance. A high collection period often signals that a company is experiencing delays in receiving payments. However, it’s important not to draw immediate conclusions from this metric alone. In the following scenarios, you can see how the average collection period affects cash flow.