An Average Collection Period (ACP) measures how long it takes businesses to collect their Accounts Receivables (AR). Often called Days Sales Outstanding (DSO), ACP helps a business determine whether it has enough cash to meet short-term financial obligations.
Companies should take less time to collect payments if their average collection period is high. With just this metric, it is difficult to conclude the same. The ACP of a company is reasonable if they issue invoices with a due date of 60 days, but extremely high if they set the due date at 30 days.
Why is keeping track of the typical collection period crucial?
The average collection period of a company provides insight into its AR health, credit terms, and cash flow. Businesses will find it difficult to plan for future expenses and projects without tracking the ACP. Businesses should keep an eye on their average collection period for a few reasons.
1) Estimate cash flow
An ACP shows a company’s collection scenario clearly. By predicting the cash flow from their accounts receivable, businesses can plan their expenses in advance.
As an example, if a company has $700,000 in AR that is 15 days old, then the payment would be expected within 1 week, given their average collection period is 20 days.
2) Analyze credit terms
Businesses benefit from a low DSO. Occasionally, things may turn out differently.
Having an ACP of 15 days, but an industry standard of 30 days, could be a sign that credit terms are too strict. Potential customers may be lost to competitors who offer better credit policies in such cases.
An example of how to calculate the average collection period?
Taking the ratio of the number of days in a year and the turnover rate of accounts receivables, the average collection period (ACP) is calculated. It is calculated by dividing net credit sales by average receivables over a year.
Example
A company makes $180,000 in credit sales in a year. At the beginning of the year, the accounts receivable were $7,000, and at the end, it was $10,000.
So,
Net Credit Sales = $180,000
Average Accounts Receivables = ($7,000+$10,000) / 2 = $8,500
Account Receivable Turnover Ratio = (Net Credit Sales / Average Accounts Receivables)
= ($180,000 / $8,500) = 21 times
Average Collection Period = (365 / Account Receivable Turnover Ratio)
= (365/21) = 17.38 days
Get insights into how to improve your business’s DSO with our excel template.
What does the average collection period mean?
ACP is an important metric for every business, but it doesn’t show much as a standalone metric. The ACP needs to be compared with a few other KPIs to get a clear picture of what it means. Among these are the average collection period in the industry and the company’s past performance.
A company can determine whether its DSO is acceptable, or if it can be improved, by comparing it to the industry standard. Additionally, past performance gives an indication of whether a business’s collection process is improving over time.
An explanation of how average collection periods work
A receivable is a money owed to a company by entities after they purchase goods or services. Most of these sales are made on credit to customers. A corporation’s current assets are listed on its balance sheet as a measure of its liquidity. Therefore, they demonstrate the ability to pay off their short-term debts without additional cash flow.
The average collection period represents the average number of days between a credit sale date and the date the purchaser remits payment. The average collection period is a good indicator of how well a company manages its AR. In order for a business to run smoothly, it must manage its average collection period.
Collection periods that are lower are generally more favorable than those that are higher. An organization that collects payments quickly has a low average collection period. There may be a problem with the company’s credit terms, however. Suppliers or service providers with more lenient payment terms may appeal to customers who find their creditors’ terms unfriendly.
The formula for Average Collection Period
A company’s average collection period is calculated by dividing its average receivable balance by its net credit sales for a given period and multiplying the result by 365.
The average collection period is calculated by multiplying the average accounts receivables by the average net credit sales.
An alternative method of calculating the average collection period is to divide the number of days in a period by the turnover rate of receivables. A ratio of days sales receivable is also defined as the formula below.
Collection Period = 365 Days / Receivables Turnover Rate
This formula is simply a more concise way of writing the average receivables turnover formula.
Average Accounts Receivables
In the formulas above, average accounts receivable is calculated by averaging the beginning and ending balances of a period. Accounting reporting tools can automate a company’s average receivables over a given period by factoring in daily ending balances.
When analyzing average collection periods, keep in mind the seasonality of accounts receivable balances. When comparing a peak month to a slow month, the average accounts receivable balance may be skewed.
Net Credit Sales
Net credit sales also contribute to the average collection period. As cash sales are not made on credit, they do not have a collection period.
Additionally, net credit sales exclude residual transactions that reduce sales amounts and often impact credit sales. Any discounts given to customers, recalls or returns of products or items reissued under warranty fall under this category.
Calculate the average collection period based on both net credit sales and average receivables. The balance sheet and income statement must match when analyzing a company’s income statement.
Importance of Average Collection Period
In Debt collection efficiency is determined by this statistician period has a variety of uses and communicates a variety of important data.
- It shows the efficiency with which debts are collected: A credit sale cannot be completed until the company has received payment. In order to reap the full benefits of a transaction, cash must be collected.
- The credit terms are strict. Clients may flee if credit terms are too tight; on the other hand, customers may seek out lenient payment terms if credit terms are too loose.
- Competitors’ performance is reported. It’s important to note that all the figures needed to calculate the average collection period are available for public companies. A company’s operations can be compared with those of other companies in this way.
- Early warnings of bad allowances are given by it. As the average collection period increases, more clients are taking longer to pay. To ensure clients are monitored and communicated with, this metric can be used to notify management to review outstanding receivables at risk of being uncollected.
- An indicator of a company’s short-term financial health. Without cash collections, a company will go bankrupt and lack the liquidity to pay its short-term debts.
Average Collection Period: How to Calculate It
As a stand-alone figure, the average collection period is of little value. You can get more value from it if you use it as a comparison tool.
A company can benefit from consistently calculating its average collection period and analyzing it over time to identify trends within its own business. Comparing one company with its competitors, either individually or as a group, can also be accomplished using the average collection period. A company’s average collection period can be used as a benchmark against another company’s performance as similar companies should produce similar financial metrics.
Also, companies may compare the average collection period with credit terms offered to customers. If invoices are issued with a net 30 due date, an average collection period of 25 days is less concerning.
The organization’s cash flow is affected by an ongoing evaluation of the outstanding collection period.
Why Is a Lower Average Collection Period Better?
In general, businesses prefer a lower average collection period over a higher one as it indicates that receivables can be collected efficiently. It may indicate that the company’s credit terms are too strict, which is a disadvantage. It is possible that stricter terms could result in a loss of customers to competitors with more lenient terms of payment.
What can a company do to improve its average collection period?
There are a few ways in which a company can improve its average collection period. Setting stricter credit terms can limit the number of days an invoice can be outstanding. To increase cash sales, it may also limit the number of clients it offers credit. Also, early payment discounts can be offered (e.g., 2% off if paid within 10 days).
Final thoughts
A business’s average collection period or DSO is crucial to its growth. A company with high ACP consistently has a problem with its accounts receivable and collection process. The order-to-cash cycle can be significantly improved by automating them with HighRadius Autonomous Receivables.
The use of automation also reduces manual intervention in the collection process, enables proactively reaching out to customers, and assists in setting up credit limits.
FAQs
1) How long does it usually take to collect a receivable?
A receivable’s average collection period can vary greatly between companies and industries. The median DSO for the machinery industry is 57 days, while that for the metals and mining industry is 32 days.
2) How does a company’s average collection period of 30 days indicate its performance?
Generally, customers who purchase products or services on credit take 30 days to clear pending accounts receivable, according to an average collection period of 30 days.
3) What can be done to reduce the average collection period?
Companies must become proactive in their collections approach to improve the average collection period. DSO can also be reduced by automating the order-to-cash process.
