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The average collection period (ACP) gauges the length of time it takes for a company to collect its accounts receivable (AR) from its clients. Customers who purchase goods or services on credit owe the company money, which is known as accounts receivable. The ability of a company to pay up its short-term debts without relying on additional cash flows, or liquidity, is shown by the amount of AR recorded as current assets on the balance sheet.
The average collection period indicates how many days pass between the date of a credit sale and the day the consumer makes payment. It illustrates how successfully an organization manages its accounts receivable and its credit policy. A business that has a shorter average collection period receives payments more quickly and has more cash on hand for operations. A business that has a larger average collection period must wait longer for its cash inflows and may have cash flow issues.
How Does the Average Collection Period Work?
You need two pieces of information to determine the average collection period: the average accounts receivable balance and the net credit sales for a specific time period. Net credit sales consist of all credit sales less any returns or allowances. These figures can be found on a company's income statement and balance sheet.
Average Collection Period = (Average Accounts Receivable / Net Credit Sales) x 365 Days
Alternatively, you can use another formula that involves dividing the number of days in a period by the receivables turnover ratio, which is the inverse of the above formula:
Average Collection Period = Days in a Period / Receivables Turnover Ratio
The receivable turnover ratio reveals how frequently a company collects its AR over a specific time period. A company that collects payments more frequently and with a shorter average collection period has a greater ratio of receivables turnover.
Let's look at an example to illustrate how to calculate the average collection period using both formulas.
Example:
Suppose that ABC Inc., a wholesale electronics company, has an average accounts receivable balance of $100,000 and net credit sales of $1 million for the year 2023. How long does it take for ABC Inc. to collect its AR on average?Using the first formula, we get:
Average Collection Period = ($100,000 / $1,000,000) x 365 Days
Average Collection Period = 0.1 x 365 Days
Average Collection Period = 36.5 Days
Using the second formula, we first need to calculate the receivables turnover ratio:
Receivables Turnover Ratio = Net Credit Sales / Average Accounts Receivable
Receivables Turnover Ratio = $1,000,000 / $100,000
Receivables Turnover Ratio = 10
Then, we divide the number of days in a year by the receivables turnover ratio:
Average Collection Period = 365 Days / Receivables Turnover Ratio
Average Collection Period = 365 Days / 10
Average Collection Period = 36.5 Days
As you can see, both formulas give us the same result: ABC Inc. takes 36.5 days on average to collect its AR from its customers.
Why Is Average Collection Period Important?
The average collection period is a crucial sign of the performance and health of a company's finances. It aids in evaluating how well a company manages its accounts receivable and cash flow cycle. Comparing companies or industries with various credit terms and regulations is also beneficial.
In general, a shorter average collection period is preferred because it indicates that a company has more cash on hand for operations, investments, and debt repayment. Additionally, it lessens the possibility of bad debts or uncollectible accounts—AR that are unlikely to be paid by clients. A business may have a competitive advantage in its market or offer alluring goods or services that clients are eager to pay for promptly if it has a lower average collection period.
However, a shorter average collection period is not necessarily desirable as it could also indicate that a company has overly severe credit terms that deter customers from making credit purchases or that it provides discounts or incentives for early payments that lower its profit margin. A business's seasonal or cyclical character, which results in larger sales and collections at particular times of the year, may also be reflected in a shorter average collection period.
An increase in the average collection period is generally unfavorable since it indicates that the company will have less cash on hand to fund operations, investments, and debt repayments. Additionally, it raises the possibility of bad debts or uncollectible accounts—AR that are unlikely to be paid by clients. A longer average collection duration may also be a sign that a company lacks a strong competitive edge in the market or that it provides subpar goods or services that clients are reluctant to pay for.
A longer average collection period is not necessarily a bad thing, though, as it may also indicate that a company offers more liberal credit conditions that draw in more clients or that its products or services are of higher quality and that clients are willing to pay more after the fact. A business that has seasonal or cyclical low sales and high collections at various times of the year may also have a longer average collection period.
The best average collection period, then, depends on a number of variables, including the business's credit policy as well as the market, the product, and the client. A company should try to strike a balance between its average period of collection, its need for cash flow, and its profitability objectives.
What Factors Affect the Average Collection Period?
There are several factors that can affect the average collection period of a business, such as:- The credit policy of a business: A company's credit policy describes the parameters under which it permits consumers to make purchases on credit. The credit period, credit limit, discount rate, and penalty rate are some of the elements that are included. A company's credit policy can affect demand for its goods and services, customer payment habits, and the likelihood of bad debts or uncollectible accounts, all of which can affect the average collection period.
- The industry and market conditions: The market and industry circumstances are the outside forces that influence the supply and demand for a good or service. They comprise elements including the level of competition, client preferences, prevailing economic trends, and legal requirements. The pricing power, the volume of sales, and the negotiating strength of a company and its consumers are all factors that the industry and market conditions can have an impact on.
- The product or service quality: A product or service's perceived value and degree of client satisfaction are referred to as its quality. It covers elements like the features, the advantages, the dependability, and the after-sales service. By altering a company's client retention, loyalty, and referral rates, a product or service's quality can have an impact on the average collection period.
- The Customer characteristics: Customers' traits and actions that influence their purchasing and payment decisions are referred to as customer characteristics. The degree of income, credit score, payment history, and payment preferences are just a few of the factors that they cover. Due to their effects on a customer's creditworthiness, ability to pay, and willingness to pay, a customer's qualities might affect the average collection period.
How to Improve the Average Collection Period?
A company's cash flow status and financial performance can be improved by reducing the average collecting period. A business may face trade-offs or incur expenditures as a result of reducing the average collecting period, thus it is necessary to do comprehensive analysis and planning.
 Here are some tips on how to improve the average collection period:- Review and revise your credit policy: To improve its effectiveness and efficiency for both your company and your consumers, you can review and change your credit policy. Your credit terms can be changed, for example, by shortening the credit period, lowering the credit limit, raising the discount rate, or enforcing the penalty rate. Additionally, you can enhance your credit evaluation procedure by carrying out more complete credit checks, creating more precise credit scores, or requesting more guarantees or collateral.
- Monitor and manage your accounts receivable: To make sure that they are paid out on time, you can manage and monitor your accounts receivable. You can employ a number of instruments and strategies, such as creating an aging schedule, delivering invoices and reminders on time, providing different payment methods, negotiating payment plans, or working with collection firms.
- Improve your product or service quality: To promote client happiness and loyalty, you might raise the quality of your goods and services. You can improve the features, advantages, dependability, and post-sale support of your good or service. Additionally, you can ask your clients for feedback and swiftly respond to any issues they may have.
- Segment and target your customers: Your clients' demographics and habits can be used to categorize and target them. You can determine which of your customers are most profitable and dependable, and then extend to them more enticing loan terms or rewards. You can also put harsher credit terms or penalties in place for your most hazardous and delinquent clients.
