Accounts Receivable Collection Period? What Is The Average Period Of Collection?
Definition of Accounts Receivable Collection Period
An accounts receivable collection period, also known as days in receivable, is the average time it takes a company to pick up money from a customer with extended credit.
This calculation is especially important because it affects the company's expected cash flow. Businesses use the collection period calculation to see if changes to their credit policies and terms are needed to ensure credit is extended only to trustworthy customers and payments are made on time. Accounts receivable is a part of a company's accounting process for keeping track of credit it has extended to customers.
Because it involves the company's policies about when to extend credit and manages the terms of the credit extension, the accounts receivable process can be particularly complicated; for example, a business might extend credit to customers with a specific credit score and give them 12 months to pay their bills in full. The accounts receivable department manages the account after it has been approved, including creating an accounting record for each credit customer, collecting and recording payments, sending payment reminders, and assessing late fees.
Allowing a customer to pay for goods or services he receives right away can put a business under much strain. Companies that offer credit must have enough cash to pay for inventory while they wait for customers to finish paying for items they already own. A company must reasonably expect when money will come in the door to manage cash flow effectively. It also needs to know how its clients pay their bills.
Managers can evaluate the time a credit account remains open by calculating a company's accounts receivable collection period. It helps them determine the length of a credit extension that is long enough to entice customers to make a purchase but not so long that the company cannot maintain inventory levels or pay bills.
Many companies keep track of their current accounts receivable collection period and compare it to previous periods to see if credit policies and terms need to be adjusted. For example, if the collection period increases, the company may need to tighten its credit policies or arrange for additional inventory financing to offset the cash flow change.
Accounts Receivable Average Period of Collection
The account receivable collection period measures the average number of days that credit customers usually make the payment to the company.
The formula for the average collection period is:
Average accounts receivable ÷ (Annual sales ÷ 365 days) = Average collection period
The best way to see if there are any long-term changes in the measure is to look at it on a trend line. In a business with consistent sales and a stable customer mix, the average collection period should be fairly consistent from month to month. When sales and customer mix change dramatically, on the other hand, this metric is likely to fluctuate significantly over time. It can be used as a performance metric for the collections department manager.
However, some of the measured performance is beyond the manager's control - changes in the amount of credit given to customers will change the average collection period, regardless of the collection efforts applied to customers.
Example of the Average Collection Period
A company has average accounts receivable of $1,000,000 and annual sales of $6,000,000. The short period of days signified good collection or credit assessment performance, while the long period of days referred to a long outstanding debt.
This will have an impact on the company's cash flow. The calculation of its average collection period is as follows:
$1,000,000 Average receivables ÷ ($6,000,000 Sales ÷ 365 days)
= 60.8 Average days to collect receivables
Explanation
The company's average collection period for the year is about 60.8 days. It is slightly high when you consider that most companies try to collect payments within 30 days.
The average collection period figure for the company can mean a few things. First, it could indicate that the company isn't as efficient as it should be at collecting accounts receivable. However, the figure shows that the company has more flexible payment terms for outstanding invoices.
Summary
The credit sales collection period is one of the most important key performance indicators that the board of directors, CEO, and especially the CFO keep a close eye on.
This is because failing to collect credit sales or convert credit sales into cash on time will have a negative impact on the company in at least two ways.
First, long-term accounts receivables can lead to bad debt, which has a negative impact that outweighs the risk of late collection. This is because the company could not profit from the sale of its goods or services and instead had to write them off as expenses. As a result, the company's financial performance will suffer.
Second, the business requires cash not only to pay suppliers for services or products purchased for its operations but also to pay its employees. Credit sales with long collection days will result in insufficient cash to pay for these items.
