Average collection period is a measure of how many days it takes a firm, on average, to collects its receivables. It indicates the efficiency of the collection process and the lower it is the shorter the cash cycle of the business is, which has a positive impact on its profitability.
What is the Average Collection Period?
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Understanding how long it takes a business to recoup the money it invests on inventory and raw materials is crucial in determining the length of its cash cycle. The cash cycle tracks how many days it takes the company to get its money back since the moment it places a purchase order until the moment it collects the money from a sale.
The average collection period doesn’t track how long it takes to collect each individual invoice, but rather, it measures the turnover of the accounts receivables as a whole, to provide a realistic picture of how the business collection’ process work. The Billing Department of most companies is the one in charge of following up on due invoices to make sure the money is collected. Eventually, if a business fails to collect most of its sales on time it will experience cash shortages, which will force it to take debt to pay for its commitments.
Average Collection Period Formula
The Average Collection Period formula is calculated below:
ACP = 365 / Accounts Receivable Turnover
The Accounts Receivable Turnover rate indicates the number of times a business’ net credit sales are turned into cash within a year or during a certain period of time. The formula for the Accounts Receivable Turnover rate is:
ART = Net Credit Sales / Avg. Accounts Receivables
Average Collection Period Equation Components
Net Credit Sales: The total sales made through commercial credit as the mean of payment.
Avg. Accounts Receivable: The sum of the beginning and ending balance of the accounts receivables divided by 2, for the time period under evaluation.
Average Collection Period Example
Bro Repairs is a small business that offers maintenance of air conditioning units to commercial establishments, offices and households. They usually give their commercial clients at least 15 days of credit and these sales constitute at least 60% of their annual $2,340,000 in revenues. At the beginning of this year, Bro Repairs accounts receivables were $124,300 and by the end of the year the receivables were $121,213.
The first thing that the owners need to do to figure out the Average Collection Period is to calculate the Accounts Receivable Turnover. Here’s how the calculation will look like:
ART = ($2,340,000 * 0.60) / (($124,300 + $121,213) / 2) = 11.4 times
With this information we can calculate the Average Collection Period, as follows:
ACP = 365 / 11.4 = 32 days.
This means Bro Repairs’ clients are taking at least twice the maximum credit period extended by the company. This has a negative effect on their cash cycle and also forces them to take debt sometimes to cover for cash shortages originated by these late payments. The company is implementing a tougher credit policy that consists in cutting credit lines to clients with 1 late payment and also, by offer a 2% discount on their bill to those who pay at their invoice’s due date.
Average Collection Period Analysis
Figuring the Average Collection Period of a business allows the management team to measure the efficiency of their Billing Teams and processes. If the ACP is higher than the average credit period extended to clients, as seen in the example above, it means the Billing Process is not working as it should. In most cases, this may be due to a lack of follow up or because of bad credit lines that should have never been extended in the first place.
To avoid this, companies should analyze their clients first, before extending credit lines to them. If a client has a history of late payments with other suppliers, the company should not provide goods or services through credit, as the collection of such sales will probably be difficult. Additionally, administrative systems should provide the Billing Team with reminders of due invoices, to prompt them to follow up in order to reduce the ratio.
A company with a consistent record of failing to collect its payments on time will eventually succumb to financial difficulties due to cash shortages, as its cash cycle will be extended. This is also a costly situation to be in, as the company will have to take debt to fulfill its commitments and this debt carries interest charges that will reduce earnings. For this reason, the efficiency of any business collection process is a crucial element to its success.
Average Collection Period Uses, Cautions, Pitfalls
Finally, while a long Average Collection Period will usually be an indication of potential issues in the collection process, the length by itself should not be the sole indication of this. Particularly small to mid-sized companies with a small client base, especially those who rely on certain key clients to make up for most of its revenues, may be more susceptible to a significant increase in the overall average collection period if one of those clients start to be late on their payments.
For this reason, evaluating the evolution of the ACP throughout time will probably give the analyst a much clearer picture of the behavior of a business’ payment collection situation. A sudden increase in the ACP should call for an in-depth analysis of what’s going on, as the reason for that increase could be that a particular client or project has been failing to meet its due dates for paying and given its size, it has affected the overall situation of the company’s receivables.
On the other hand, companies with declining sales may see an increase in their ACP, if the period of time being analyzed is too short, as the lower recent sales vs. the larger receivables from past higher sales may distort the ratio. For this reason, it its advised that the ACP analysis is made annually, to avoid such distortions coming from unexpected changes in either sales, particular difficulties to collect certain payments or even due to seasonality.