What is the Collection Ratio?

The collection ratio is the average period of time that an organization’s trade accounts receivable are outstanding. It is a useful measurement for evaluating the effectiveness of an organization’s credit granting processes and receivable collection systems. A lengthy period during which receivables are outstanding represents an increased credit risk for the seller, and also requires a larger working capital investment to fund the underlying inventory that was sold. However, a business may deliberately allow a long collection period in order to service higher credit-risk customers to which its competitors are unwilling to sell.

How to Calculate the Collection Ratio

The formula for the collection ratio is to divide total receivables by average daily net credit sales. The calculation is as follows:

(Average daily net credit sales ÷ Trade accounts receivable = Collection ratio

In the formula, net credit sales refers to all sales made on credit (that is, not in cash), net of all sales returns and allowances. Trade receivables refers to the amount of billed sales outstanding on goods and services sold in the ordinary course of business. Trade receivables does not include any extraneous receivables, such as advances owed by employees.

Advantages of the Collection Ratio

There are several advantages to monitoring an organization’s collection ratio, which are as follows:

Enhances cash flow. By monitoring the collection ratio, management can put more emphasis on the early collection of outstanding receivables. By doing so, the organization collects cash sooner, which reduces its need for cash. Better cash flow can result in more dividends for investors, and/or a greater investment of funds back into the business.
Reduces external financing requirements. With more robust cash flow, a business requires less external financing. This reduces its interest expense, and also makes it less reliant on lenders - which can be an advantage when credit is tight.
Improved credit rating. By properly managing the collection ratio to achieve better cash flow, a business can earn a higher credit rating. With an improved credit rating, it is easier to qualify for a loan, and may also reduce the interest rate charged by the lender.