Average Collection Period Definition
The average collection period is a financial metric used to assess how efficiently a company is managing its accounts receivable. It shows the average number of days it takes for a company to collect payments from its customers after a sale has been made on credit. This metric is important because it helps businesses understand their cash flow situation and the effectiveness of their credit and accounts receivable collection policies.
Average Collection Period Calculation
You can use the average collection period calculator below to calculate ACP:
Average Collection Period Ratio = (Average Accounts Receivable/Total Credit Sales) × Days in Period
- Average Accounts Receivable is the average amount of money owed to the company by its customers during a specific period.
- Total Credit Sales is the total value of sales made on credit during the same period.
- Days in Period is the number of days in the period being analyzed
A shorter average collection period is better, as it shows that the company can collect its receivables more quickly, which can lead to better cash flow and a lower risk of bad debts. Conversely, a longer collection period suggests issues with the credit policy or collection processes, which could affect the company's liquidity.
Average Collection Period Example
Let's walk through an example to illustrate how to calculate the average collection period.
Suppose Company A, wants to calculate its ACP for the year 2023.
Here are the relevant figures:
Total Credit Sales for 2023: $600,000.
Average Accounts Receivable for 2023: To calculate this, you need the accounts receivable at the beginning and end of the year. Let's say it was $50,000 at the beginning (January 1, 2023) and $70,000 at the end (December 31, 2023).
So, the average accounts receivable would be (50,000 + 70,000) / 2 = $60,000.
Now, apply these figures to the formula for ACP:
Average Collection Period = (60,000/600,000)×365
= 36.5 days
So, the ACP for Company A in 2023 is approximately 36.5 days. This means that on average, it takes the company about 36.5 days to collect payments from its customers after making a sale on credit.
Average Collection Period vs. Accounts Receivable Turnover Ratio
The major difference between the ACP and the accounts receivable turnover ratio (ARTR) lies in their focus and the way they are calculated:
Average collection periods measure the average number of days it takes a company to collect payments from its customers after a credit sale. It's calculated by dividing the average accounts receivable by total credit sales and then multiplying by the number of days in the period.
Receivables turnover ratio shows how many times a company collects its average receivables during a period. It's calculated by dividing total credit sales by the net accounts receivable.
ACP focuses on the time (in days) it takes to collect receivables, while the accounts receivable ratio shows how often receivables are collected over a period.
Average Collection Period Benefits
The Average Collection Period (ACP) provides several benefits as a financial metric:
- Cash Flow Insight: ACP helps a company perform cash flow forecasting easily and understands how quickly it is converting its accounts receivables into payment. This is crucial for managing cash flow, as faster collections can lead to more available cash for operations, investments, and debt payments.
- Credit Policy Assessment: It allows a company to evaluate the effectiveness of its credit policies. A shorter collection period shows efficient credit and collection processes, while a longer collection period might suggest the need for tighter credit policies or improved collection efforts.
- Financial Health Indicator: ACP can be an indicator of the company's financial health. Consistently high ACP might signal potential issues with liquidity or the risk of bad debts, affecting the company's overall financial stability.
- Benchmarking and Performance Tracking: Companies can use ACP to benchmark against industry standards or competitors, providing insight into relative performance. It also allows for tracking improvements or deteriorations in receivables management.
- Customer Creditworthiness: ACP can help in assessing the creditworthiness of customers. Patterns in collection periods may show which customers are consistently paying late, enabling targeted net terms.
- Decision Making: This metric can inform strategic decisions, like setting a credit term, pursuing new customer segments, or starting collection actions. It helps balance between extending credit to boost sales and maintaining a healthy cash flow.