How to Calculate the Average Collection Period
The average collection period is a crucial financial metric that helps businesses assess their efficiency in collecting payments from customers. It provides insights into how quickly a company can convert its receivables into cash. By understanding the average collection period, businesses can make informed decisions regarding credit policies, debt collection efforts, and overall financial health. In this article, we will discuss how to calculate the average collection period and its significance in managing a company’s cash flow.
The average collection period is calculated using the following formula:
Average Collection Period = (Accounts Receivable / Net Credit Sales) Number of Days in a Year
To calculate the average collection period, you need to gather two pieces of information: the accounts receivable and the net credit sales.
1. Accounts Receivable: This represents the total amount of money owed to the company by its customers for goods or services sold on credit. It can be found on the balance sheet under the current assets section.
2. Net Credit Sales: This refers to the total sales made on credit during a specific period, excluding any returns, allowances, or discounts. It can be found on the income statement under the revenue section.
Once you have these two figures, follow these steps to calculate the average collection period:
1. Divide the accounts receivable by the net credit sales to obtain the accounts receivable turnover ratio.
2. Multiply the accounts receivable turnover ratio by the number of days in a year (365 days) to get the average collection period.
For example, let’s say a company has $100,000 in accounts receivable and $500,000 in net credit sales.
1. Accounts Receivable Turnover Ratio = $100,000 / $500,000 = 0.2
2. Average Collection Period = 0.2 365 = 73 days
This means that, on average, it takes the company 73 days to collect payments from its customers.
Understanding the average collection period is essential for several reasons:
1. Cash Flow Management: A shorter average collection period indicates that the company can convert its receivables into cash more quickly, which is crucial for maintaining a healthy cash flow.
2. Credit Policies: By analyzing the average collection period, businesses can adjust their credit policies to ensure that they are extending credit to customers who are more likely to pay on time.
3. Debt Collection Efforts: A longer average collection period may require the company to invest more resources in debt collection efforts, such as sending reminders or pursuing legal action.
4. Financial Health: The average collection period is a key indicator of a company’s financial health and can be used to compare its performance with industry benchmarks.
In conclusion, calculating the average collection period is a straightforward process that provides valuable insights into a company’s financial performance. By understanding this metric, businesses can make informed decisions to improve their cash flow, credit policies, and overall financial health.
