How to Calculate Average Collection Period in Accounts Receivable

average collection period meaning

More sophisticated accounting reporting tools may be able to automate a company’s average accounts receivable over a given period by factoring in daily ending balances. A lower average collection period is generally more favorable than a higher one. A low average collection period indicates that the organization collects payments faster. Customers who don’t find their creditors’ terms very friendly may choose to seek suppliers or service providers with more lenient payment terms.

  • Ideally, a company strives to maintain a balance where it can collect its receivables quickly and defer its payables for as long as possible.
  • Therefore, the best way to ‘optimize’ the average collection period is to ensure that companies incentivize customers to pay early via discounts and work towards extending credit limits from suppliers.
  • In other words, its current assets are reducing, subsequently shrinking its working capital.
  • Every year, more than 40% of small businesses fail due to insufficient funds and cash flow problems.
  • The average collection period is calculated by dividing the net credit sales by the average accounts receivable, which gives the Accounts receivable turnover ratio.

General economic conditions could be impacting customer cash flows, requiring them to delay payments to their suppliers. This issue is a major one, since the problem arises entirely outside of the business, giving management no control over it. On the other hand, a short average collection period indicates that a company is strict or quick in its collection practices.

Average Collection Period Formula: How It Works and Example

But they only managed to collect $ 10,000, which is their accounts receivable balance. Unless you run a finance-based business, accessing their financial statements is not possible for you. Yet, average collection period meaning with the calculation of average collection period, you can predict and understand their creditworthiness. Although cash on hand is vital for all businesses, some rely more on it than others.

  • Let us take a look at a numerical example of calculating the average collection period.
  • In either situation, collections receive less attention, resulting in a rise in the quantity of receivables outstanding.
  • On the other hand, the DSO ratio estimates how long it takes a company to collect payments after a sale has been made.
  • Therefore, businesses should aim to keep their average collections period as short as possible.
  • Hence, the Average Collection Period can also be defined as an indicator that reflects the effectiveness, as well as the efficiency of the Account Receivable practices by the company.
  • Management has decided to grant more credit to customers, perhaps in an effort to increase sales.

For example, if the average collection period is 25 days, and outstanding receivables totaling $500,000 have a 20-day maturity, businesses can anticipate receiving payments within approximately a week. Accounts receivable refers to money owed to a corporation by entities when they acquire goods and/or services. AR is shown as a current asset on a company’s balance sheet and measures its liquidity. As so, they demonstrate their ability to pay off short-term loans without relying on further income flows. The company has a tight credit policy because it plans to pay off its short debt by the end of the fiscal year.

Optimize Your Average Collection Period and A/R

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. 💡 To calculate the average value of receivables, sum the opening and closing balance of your required duration and divide it by 2.

To find the ACP value, you would need to divide a company’s AR by its net credit sales and multiply the result by the number of days in a year. Real estate and construction companies also rely on steady cash flows to pay for labor, services, and supplies. Accrual accounting is a business standard under generally accepted accounting principles (GAAP) that makes it possible for companies to sell their goods and services with credit.