Average Collection Period Overview, Importance, Formula

If Company ABC aims to collect money owed within 60 days, then the ACP value of 54.72 days would indicate efficiency. However, if their target collection period is 30 days, the ACP value of 54.72 days would be too high, indicating inefficiency in the company’s collection efforts. In this example, first, we need to calculate the average accounts receivable. The company’s top management requests the accountant to find out the company’s collection period in the current scenario. In addition to being limited to only credit sales, net credit sales exclude residual transactions that impact and often reduce sales amounts. This includes any discounts awarded to customers, product recalls or returns, or items re-issued under warranty.

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Average collection period refers to the amount of time it takes for a business to receive payments owed by its clients in terms of accounts receivable (AR). Companies use the average collection period to make sure they have enough cash on hand to meet their financial obligations. The average collection period is an indicator of the effectiveness of a firm’s AR management practices and is an important metric for companies that rely heavily on receivables for their cash flows. Average collection period is a company’s average time to convert its trade receivables into cash. It can be calculated by dividing 365 (days) by the accounts receivable turnover ratio or average accounts receivable per day divided by average credit sales per day.

In the first formula, we first need to determine the accounts receivable turnover ratio. As an alternative, the metric can also be calculated by dividing the number of days in a year by the company’s receivables turnover. The average collection period measures a company’s efficiency at converting its outstanding accounts receivable (A/R) into cash on hand. The best way that a company can benefit is by consistently calculating its average collection period and using it over time to search for trends within its own business. The average collection period may also be used to compare one company with its competitors, either individually or grouped together.

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When there’s an issue with an invoice, your customer can leave a comment directly on the invoice or proceed with a short payment and specify why. It’s vital that your accounts receivable team closely monitor this metric and keep it as low as possible. We’ll discuss how to analyze average collection period further in this article. The ACP value could also decrease if a company has imposed shorter payment deadlines and tightened its credit policies.

The smaller this number, the more efficient an analyst could interpret their receivables management. 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.

1. Every business is unique, so there’s no right answer to differentiate a “good” average collection period from a “bad” one.
2. The average receivables turnover is simply the average accounts receivable balance divided by net credit sales; the formula below is simply a more concise way of writing the formula.
3. Collaborative AR automation software lets you communicate directly with your customers in a shared cloud-based portal, helping you resolve these problems efficiently.
4. Identifying this timeline is especially important for businesses that primarily rely on accounts receivable to fund their cash flow, such as banks and real estate and construction companies.
5. You need to calculate the average accounts receivable and find out the accounts receivables turnover ratio.

Formula for Average Collection Period

In addition, what is a setup charge properly managing the ACP and keeping it low is necessary for any company to operate smoothly. The average collection period is the time a company takes to convert its credit sales (accounts receivables) into cash. It provides liquidity to the company to meet its short-term needs or current expenses as and when they become due. The average collection period is an accounting metric used to represent the average number of days between a credit sale date and the date when the purchaser remits payment. A company’s average collection period is indicative of the effectiveness of its AR management practices.

The average collection period is used a few different ways to measure cash flow performance. Generally speaking, companies want to minimize their average collection period. Overall shorter collection periods increase liquidity and generate better cash flow efficiency. Companies use the average collection period as a key aspect of operating cash flow management, determining the optimal collection period for their company’s needs. Oftentimes, companies will also consider accounts receivable write-offs in conjunction with average collection period days for a broader assessment. Creditors may also follow average collection period data and may even include threshold requirements for maintaining credit terms.

This creates a great moral hazard among the recipients of medical services, since their consumption does not bear the full cost of service provision. Providers of health care must be on top of collections to keep the doors open for non-paying customers. Construction and real estate companies rely on sufficient cash flow to buy materials and deploy labor towards projects that don’t immediately generate income. Moreover, rental real estate tends to run into constant cash flow need; poor receivables management cannot be tolerated for long. At the beginning of the year, your accounts receivable were at $5,000, which increased to $10,000 by year-end. 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.

A company’s average collection period reflects the efficiency of accounts receivable management practices. It can be calculated by taking total credit sales and dividing that by the multiple of average receivables and number of days in the time period. The term average collection period, or ACP, describes the amount of time taken by an organization to convert its accounts receivables to cash. Accounts receivable turnover ratio describes how efficiently a business can collect a debt owed and maintain a credit policy. It is calculated by dividing net credit sales by average accounts receivable.

However, we recommend tracking a series of accounts receivable KPIs and to develop a system of reporting to more accurately—and repeatedly—gauge performance. Not all metrics work for all businesses, so having an abundance of performance indicators is more valuable than relying on a single number. When disputes occur, there is often a string of back and forth phone calls that draws out the process of coming to an agreement and getting paid. Collaborative AR automation software lets you communicate directly with your customers in a shared cloud-based portal, helping you resolve these problems efficiently.

Companies strive to receive payments for goods and services they provide in a timely manner. Quick payments enable the organization to maintain the necessary level of liquidity to cover its own immediate expenses. It means that Company ABC’s average collection period for the year is about 46 days. It is slightly high when you consider that most companies try to collect payments within 30 days. Medical and health care companies have a unique challenge, since a great number of medical payments are made through third parties.

AR is listed on corporations’ balance sheets as current assets and measures their liquidity. As such, they indicate their ability to pay off their short-term debts without the need to rely on additional cash flows. One of the simplest ways to calculate the average collection period is to start with receivables turnover which is calculated by dividing sales over accounts receivable to determine the turnover ratio. Most modern businesses use accrual accounting, offering their customers the option to buy now and pay later.

Calculating the average collection period and keeping it relatively low allows businesses to maintain liquidity. It also provides the management with a general idea of when they might be able to make larger purchases. Although cash on hand is important to every business, some rely more on their cash flow than others. This metric should exclude cash sales (as those are not made on credit and therefore do not have a collection period). Generally, you want to keep your average collection period or DSO under 45 days; however, this number can vary by industry.

Customers who don’t find their creditors’ terms very friendly may choose to seek suppliers or service providers with more lenient payment terms. To address your average collection period, you first need a reliable source of data. When you log in to Versapay, you get a clear four tax scams to watch out for this tax season dashboard of the current status of all your receivables. Your entire team can access your customers’ entire payment history, giving you a clear picture of your collection efforts. The average collection period calculation is often used internally for analyzing the company’s liquidity and the efficiency of its accounts receivable collections. Alternatively, you can divide the number of days in a year by the receivables turnover ratio calculated previously.