Why You Need to Know the Average Collection Period Formula

Why You Need to Know the Average Collection Period Formula

Banks like to see large values for accounts receivable on a company's balance sheet. A larger value of accounts receivable proves that a company gets a healthy amount of business and generally indicates solid cash flow.

Having more money in accounts receivable usually leads to more favorable lending rates. Such rates can be the difference between profitability and bankruptcy for a small business. The value of accounts receivable is an important metric, but so is the amount of time it takes to convert those accounts receivable into cash.

Your company's average receivables might be astoundingly good, enough to make any financial analyst give you an impromptu thumbs up. However, if you're not collecting on your accounts receivable balance until well after the due dates outlined in your payment terms and credit terms, you've got a cash flow problem.

Calculating the Formula

Why You Need to Know the Average Collection Period Formula

The average collection period calculation is simple:

(Average Accounts Receivable ÷ Net Credit Sales) x Number of Days in Period= Average Collection Period

What this result represents is how quickly your company can transform accounts receivable into cash. Let's break down the parts of the average collection period formula to understand what goes into one of the most important metrics for a company's health.

Average Accounts Receivable

Before we can know the average collection period, we need to calculate its parts. Finding the average accounts receivable uses the beginning and ending accounts receivables values from the period of time you want to measure.

Usually, this period of time is one year. If that is the case, find the total value of accounts receivable from the beginning and end of the year. As long as you find the values for the beginning and end of the period, whatever it may be, you'll get the result you want.

For example:

Beginning accounts receivable amount: $100,000

Ending accounts receivable amount: $150,000

Add the two together to get $250,000, and divide that figure by 2 for the average accounts receivable, which would be $125,000.

Net Credit Sales

Net credit sales are sales where cash was collected at a later date after the sale. The formula to calculate net credit sales is:

Sales on credit – Sales returns – Sales allowances = Net Credit Sales

For example- A company had $500,000 in sales on credit, $50,000 in returns, and $50,000 in allowances for a total net credit sales of $400,000.

Number of Days in Period

Why You Need to Know the Average Collection Period Formula

Determining the number of days in the average accounts receivable will give you the data you want for your average collection period. In this case, since one year is the most common time frame, we'll say 365.

Plug these numbers into our formula and we get:

($125,000 ÷ $400,000) x 365 = 114.06 days

This result means it takes a whopping 114 days — or nearly four months — for this fictional company to collect on its accounts receivable. This company's average collection period needs to improve!

The goal is a lower average collection period. Being under 30 days is a solid number since most businesses want to collect their customers' payments within a month.

Other Formulas You Should Know

Why You Need to Know the Average Collection Period Formula

While the average collection period formula is essential, so are these other fundamental calculations:

Accounts Receivable Turnover Ratio

Another financial ratio your company can use to determine its health is the accounts receivable turnover ratio. It's calculated as:

Net Credit Sales ÷ Average Accounts Receivable = Accounts Receivable Turnover Ratio

It's the opposite formula from the first part of the average collection period formula, so in the case of our fictional company, it would be:

$400,000 ÷ $125,000 = 3.2

In other words, the company collected on its accounts receivable about 3.2 times in a fiscal year.

Improving Average Collections

Why You Need to Know the Average Collection Period Formula

If your customers aren't paying on time, then you need to implement some changes. Your average credit sales might be high, but you have to turn those credits into cash!

Collection Policies

You may need to examine your collection policies. If your credit policy allows customers to pay whenever they feel like it, then they will, and they will never feel like it. If the average number of days it takes for a customer to pay their invoice is beyond a month, you will need to alter your policy to specify that payment is due within thirty days.

Invoice Communication

Put due dates, total amounts, contact information, payment terms, and payment methods on your customer invoices. Put important dates and payment amounts in bold, highly visible fonts and colors. Sometimes customers don't pay because they're confused about how much they owe or where to send their payment.

Improve Communication

Use accounting software to keep track of payments and who still owes money. You can set reminders to contact customers or let the software send out reminders.

Stay in touch with your customers and remember that the vast majority are happy to pay, but life gets in the way. If you have particularly unruly customers or customers who refuse to or can't pay, you may need to turn their accounts over to a collection agency.

Improve Your Invoicing With HappyAR

Improve Your Invoicing With HappyAR

If you truly want to transform your invoicing, then you need HappyAR. HappyAR is a full toolkit that makes invoicing simple and gets you paid faster and in full. It provides fully automated workflows and complete integration with your existing accounting software. Talk to HappyAR today; your accounts receivable will get the shot in the arm it needs.

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