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

15 April, 2022
10 mins
Brett Johnson, AVP, Global Enablement

Table of Content

Key Takeaways
Introduction
What Is Average Collection Period?
How to Calculate Average Collection Period?
Real-life Example of How to Calculate Average Collection Period Ratio
How to Interpret the Average Collection Period?
Why Is It Critical to Track the Average Collection Period?
Wrapping Up
FAQs

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Key Takeaways

  • The ACP signifies the average days a company takes to collect payments from customers, reflecting its efficiency in converting accounts receivable into cash.
  • While high ACP may signal delays in receiving payments comparing it with industry standards and with other key performance indicators is crucial for a clearer picture.
  • AR automation empowers businesses to enhance their order-to-cash cycle. Embrace the efficiency of automation to streamline collections and minimize manual efforts.
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Introduction

In today’s business landscape, it’s common for most organizations to offer credit to their customers. After all, very few companies can rely solely on cash transactions for all their sales.If your business follows suit by extending credit to customers, it becomes crucial to efficiently manage payment collections.

The average collection period emerges as a valuable metric to help in this endeavor. It stands as an essential financial metric that grants businesses insight into the speed at which they can convert credit sales into actual cash.

In this article, we explore what the average collection period is, its formula, how to calculate the average collection period, and the significance it holds for businesses.

What Is Average Collection Period?

The average collection period (ACP) is a metric that reveals the average time it takes for a company to collect payments from customers for credit sales. It measures the company’s efficiency in converting accounts receivable into cash.

By monitoring and improving the ACP, companies can enhance their liquidity, reduce the risk of bad debts, and maintain a healthy financial position.

How to Calculate Average Collection Period?

The average collection period is calculated by dividing the net credit sales by the average accounts receivable, which gives the Accounts receivable turnover ratio. To determine the average collection period, divide 365 days by the accounts receivable turnover ratio.

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Related Read: Days Sales Outstanding: What Is It & How It Can Optimize Your A/R

Real-life Example of How to Calculate Average Collection Period Ratio

Let’s understand average collection period with an example: 

Say, your company generated $150,000 through credit sales over a year. At the beginning of the year, your accounts receivable were at $5,000, which increased to $10,000 by year-end.

By using the formula, we calculate the Account Receivable Turnover Ratio as follows: 

Net Credit Sales = $150,000 Average Accounts Receivables = ($5,000 + $10,000) / 2 = $7,500 

account receivable Turnover Ratio = (Net Credit Sales / Average Accounts Receivables) = ($150,000 / $7,500) = 20 times

Now, translating this into practical terms for you: Average Collection Period = (365 / Account Receivable Turnover Ratio) = (365 / 20) = 18.25 days.

This means that, on average, it takes around 18.25 days for your company to collect payments from customers after a credit sale. This metric helps you gauge how effectively you're converting credit sales into actual cash flow

How to Interpret the Average Collection Period?

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.

Let’s consider an example to highlight this: imagine a company with an ACP of 50 days, issuing invoices due in 60 days – here, the ACP appears reasonable. Yet, if the same company sets a due date of 30 days, the ACP would seem notably higher. This illustrates how the interpretation of the average collection period depends on payment terms and practices.

While ACP holds significance, it doesn’t provide a complete standalone assessment. It’s essential to compare it with other key performance indicators (KPIs) for a clearer understanding.

This comparison includes the industry’s standard for the average collection period and the company’s historical performance. 

By benchmarking against the industry standard, a company can gauge easily whether the number is acceptable or if there is potential for improvement.

Why Is It Critical to Track the Average Collection Period?

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.

  1. Strategic cash flow projection: The ACP offers a clear window into a company’s collections landscape. By forecasting cash flow from accounts receivable, businesses can proactively plan expenses. For instance, if the ACP is 25 days and outstanding receivables amount to $500,000 with a 20-day maturity, companies can expect receipt within about a week.
  2. Evaluating Credit Terms: ACP plays a vital role in credit terms assessment. While a lower number is generally favorable,comparing it with other companies in your industry is essential. Deviations can indicate excessively stringent credit terms.. For instance, if a company’s ACP is 15 days while the industry average is approximately 30 days, it could impede customer acquisition. Striking the appropriate balance is of paramount importance.

A company’s average collection period is a key indicator, offering a clear window into its AR health, credit terms, and cash flow. By forecasting cash flow from accounts receivable, businesses can proactively plan expenses, strategically navigating the dynamic landscape of credit sales.

Ever wondered how much it costs companies to collect $1000 of revenue? 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.

[Learn more: The Cost of Collections – Unveiling the Dynamics]

Wrapping Up

The average collection period signifies the average duration a business requires to collect payments owed by clients or customers. Vigilantly tracking this metric is essential to maintain sufficient cash flow for meeting immediate financial obligations.

While the average collection period may not hold a standalone meaningful value to a business, consistently high ACP could indicate issues with your accounts receivable and collection process; automating the AR process could enhance efficiency. 

According to a PYMNTS report, 88% of businesses automating their AR processes see a significant reduction in their DSO. Automation can also help reduce manual intervention in collection processes, enabling proactive communication with customers and helping in the establishment of appropriate credit limits.

By automating their AR process with HighRadius Autonomous Receivables, businesses can significantly improve their order to cash cycle.

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FAQs

  1. What is a good average collection period?

    There isn’t one right or good number – it varies, but a shorter period often shows that a business is efficiently turning credit sales into cash and managing cash flow well.

  2. What does a longer collection period mean? 

    A longer average collection period suggests delays in receiving payments, potentially signaling issues with accounts receivable management and cash flow.

  3. How can I improve my collection period?

    You can improve your collection period by implementing efficient credit policies, offering incentives for early payments, automating collection processes, and maintaining effective communication with customers.

  4. What does the average collection period tell?

    The average collection period assists in evaluating a company’s financial well-being, credit strategies, and cash flow. Comparing it with industry norms and historical data enhances its value as a metric.

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