Definition of Average Collection Period
Average Collection Period is defined as the amount of time that is taken by the business to receive payments from its customers (or debtors) against the credit sales that have been made to these clients. This is a metric that is used by businesses to determine the number of days it takes for the cash to be received, from the day of the sale.
Businesses today are highly reliant on credit during their day-to-day business transactions. Businesses need to realize the importance of the Cash Conversion Cycle when working with credit transactions.
Liquidity is highly important to ensure that the business continues to work and function smoothly. It enables the company to meet its day-to-day expenses without any unprecedented delays.
Therefore, the Average Collection Period is a highly resourceful metric that helps the company to determine its credit policy, and if it needs to be changed to improve the cash conversion cycle or the liquidity position of the company.
Hence, the Average Collection Period can also be defined as an indicator that reflects the effectiveness, as well as the efficiency of the Account Receivable practices by the company. This is primarily because companies rely significantly on the Accounts Receivables of the company.
Detailed Explanation of Average Collection Period
Accounts Receivables is defined as a business term to describe the customers which have purchased goods and services on credit from the organization. Companies are known to make these sales to customers on a credit basis.
It is mentioned in the Balance Sheet as a Current Asset, because this is the amount that is likely to be recovered from the customers, incurring a cash inflow into the company.
This figure is perhaps the most significant figure that indicates the ability of the company to pay off the short-term debts without relying on any additional cash flows, or sources of funding.
Given this definition of Accounts Receivables, the Average Collection Period can be defined as the timeline that represents the average number of days between a credit sale, as well as the date when the customer pays the organization for the goods and services that have been purchased.
From the business’s perspective, this metric is resourceful in terms of determining the overall efficacy of the account receivable practices and policies that are currently in play. Businesses must be able to ensure that their average collection period is sorted, to operate smoothly.
Therefore, from an organization’s perspective, lower average collection periods are more favorable as compared to higher ones. This is because it implies that the business can collect the money more quickly, as compared to other companies.
However, it also has an alternate perspective to it. Too short average collection period might also indicate that the company has a strict credit policy in place, which might result in customers being driven away to other competitors that might offer better credit terms to the customers.
Formula for calculating Average Collection Period
Average Collection Period is calculated using average receivables, and the total sales figure for the period. The formula used to calculate the Average Collection Period is as follows:
Average Collection Period = Average Accounts Receivable / Net Sales of the Organization x 365
Average Accounts Receivables are calculated by adding the Accounts Receivable at the start of the year, and Accounts Receivable at the end of the year, divided by 2.
Alternatively, the Average Collection Period can also be calculated using the Accounts Receivable Turnover formula. To calculate the Average Collection Period using the Accounts Receivable Turnover Ratio, the following formula is used:
Average Collection Period = 365 / Accounts Receivable Turnover
Example of Calculating Average Collection Period
The concept of the Average Collection Period is illustrated in the following example:
Higgs Co. deals with various chemicals and industrial solvents. They mainly sell goods and services on credit. On 1st January 2019, they had an Accounts Receivable Balance equivalent to $20,000. On 31st December 2019, the Accounts Receivable Balance amounted to $30,000. The Net Sales during the year ended 31st December 2019 amount to $100,000.
In the scenario mentioned above, it can be seen that Average Collection Period will be calculated using the following formula:
Average Receivables = (Opening Balance of AR + Closing Balance of AR)/2
Average Receivables = ($20,000 + $30,000)/2 = $25,000
Average Collection Period = Average Accounts Receivable / Net Sales of the Organization x 365
Average Collection Period = $25,000 / $100,000 *365 = 91.25 days
This implies that the customer of Higgs Co., on average, take a period of 91.25 days in order to settle their debts.
Interpretation of Average Collection Period
The Average Collection Period above can be defined as the metric that determines the number of days between the sale transaction, and the time when the customer pays the organization.
In the example that has been mentioned above, it can be seen that the average collection period is used for the internal decision-making of the company. As a standalone figure, it might not be much resourceful for the company.
However, in the long affair of things, the Average Collection Period tends to be compared to other industry averages to gauge if the credit policy of the company is working well enough to derive the best possible results.
For example, if the industry average Average Collection Period was 40 days, the organization has an Average Collection Period of 91 days, this reflects that the company has a relatively lenient credit policy that needs to be tweaked to improve the cash flow position.
In the same manner, the Average Collection Period is also used in conjunction with Days Payable Outstanding. This is the exact opposite of the average collection period. Normally, companies have the same amount of time between Days Payable Outstanding, as well as Average Collection Period.
If the cash conversion cycle needs to be changed for a better liquidity-related position, the average collection period needs to be aligned with the number of days the organization generally gets to pay back its creditors. This might help in improving the liquidity position of the company.
How Can Companies Reduce the Average Collection Period?
Average Collection Period is a metric that spans across a considerable time frame since beginning year balance and ending year balance both are included in the calculation. Therefore, if this metric needs to be reduced, i.e. number of days needs a reduction, several different strategies can be implemented by companies.
These strategies mainly revolve around offering early payment discounts. This acts as an incentive for the buyers to pay early, to avail the given discounts.
Additionally, organizations can also constantly send reminders to the creditors to ensure that they pay their liabilities on time. These constant reminders might help debtors pay earlier than the agreed-upon date, eventually resulting in a reduction in the cash collection period.
However, this does not necessarily imply that companies should continue to push customers for quicker payments. This often leads to customers switching to other competitors that might offer a better credit policy.
Therefore, the best way to ‘optimize’ the average collection period is to ensure that companies incentivize customers to pay early via discounts and work towards extending credit limits from suppliers.
