Average Collection PeriodDefined along with Examples

Written By:
Adiste Mae

What is an Average Collection Period?

A company’s sales made on credit are referred to as Accounts Receivable.

The Average Collection Period is the time it takes for companies to collect payments owed by their customers.

How efficient and effective a management’s Accounts Receivable process is, is determined by how well accounts receivable balances are collected.

This helps companies rely on Accounts Receivable for their Cash Flow, especially if the majority of their sales are made on credit. 

How Average Collection Periods Work

One of the ways that companies can raise their sales is to allow their customers to purchase goods or services payable at a later time.

Upon revenue recognition, an entry to record the sales and Accounts Receivable will be made.

Under the Balance Sheet, Accounts Receivable is listed under Current Assets and is one of the measures of a company’s liquidity – the capacity to cover short-term debts. 

The Average Collection Period is an accounting metric that determines the average number of days it takes companies to receive payments from credit sales.

When the Average Collection Period is shorter, it is indicative of the best AR practices of the company.

However, it could also indicate that there are stricter credit terms imposed on the customers.

Generally speaking, a shorter Average Collection Period means that the accounts receivable is more reliable when it comes to projecting the cash flows. 

The calculation of the Average Collection Period is done by adding the AR beginning balance and AR Ending balance and then dividing their sum by two.

Another way of computation is to divide the sum by 365 days to compute the average for a whole year. 

Special Considerations

Average Collection Periods is a metric best used as an accounting comparative tool within the business to analyze trends, or compared with other companies of the same industry.

Across businesses of the same industry, it is encouraged for them to have the same financial metrics when computing for the average collection periods so that it can be benchmarked against the performance of another company.

It can also be used to analyze the credit terms extended to their customers.

For example, an average collection period of 29.5 days when the company provides a 30 day credit period means that their customers are well within the terms that they provide, and thus, is not a concern for the business.

However, when the average collection period is 40 days, they have to revisit the credit terms provided to the clients. 

How to Calculate the Average Collection Period

The formula to compute for the Average Collection Period requires the Accounts Receivable balance to be divided by the total sales for the period.

The quotient will then be multiplied by the total number of days for a year (365 days). 

Average Collection Period = (Average Balance of Accounts Receivable / Net Sales) x 365 days. 

For example, Company X has a beginning AR balance of $65,000 closed the year with an AR balance of $80,000.

The Net Sales for the period is $850,000. 

First, the average balance of accounts receivable needs to be computed by adding the beginning AR balance and the ending AR balance and then dividing it by two which is $72,500 (($65,000 + $80,000)/2). 

Average Collection Period = ($72,500 / $850,000) x 365 days

Average Collection Period = 31.13 days

Most companies collect accounts receivable within 30 days so 31.13 days is actually a good sign.

If the company had a longer average collection period, they would have to revisit their credit collection policies and the credit terms provided to their customers.

When they are able to collect receivables within a shorter period of time, they will be able to meet short-term obligations.

Otherwise, they will face cash flow issues. 

Accounts Receivable (AR) Turnover

Another metric used by companies to measure how efficiently a company collects the money owed by customers is the Accounts Receivable Turnover Ratio, computed by dividing Net Sales by the Average Accounts Receivable. 

Based on the example above, the AR Turnover is 11.72 ($850,000 / $72,500). 

The Average Collection Period can also be computed using the AR Turnover by dividing the total number of days by the AR Turnover.

In this case, it is 365 days / 11.72, which will still be 31.13 days. 

Why is the Average Collection Period Important?

Companies that rely heavily on credit sales need to be able to have effective accounts receivable management for the following reasons:

Maintain Liquidity

A company’s liquidity is measured by how quickly it will be able to convert its assets to cover short-term liabilities.

With a shorter average collection period, the liquidity is high.

This will also provide an indication of the company’s ability to make larger purchases in the future. 

Plan for future expenses

When companies have a shorter collection period, it means that they are able to rely on their cash flows and plan for future purchases and growth.

When they can collect payments faster, they will then be able to pay their bills on time.