Average collection period definition
/What is the Average Collection Period?
The average collection period is the average number of days required to collect invoiced amounts from customers. The measure is used to determine the effectiveness of a company's credit granting policies and collection efforts. It is especially useful for businesses that operate with minimal cash reserves, and so need to understand the exact nature of their cash inflows. The formula for the average collection period is:
Average receivables ÷ (Annual sales ÷ 365 days) = Average collection period
The measure is best examined on a trend line, to see if there are any long-term changes. In a business where sales are steady and the customer mix is unchanging, the average collection period should be quite consistent from period to period. Conversely, when sales and/or the mix of customers is changing dramatically, this measure can be expected to vary substantially over time. It can be used as a performance metric for the manager of the collections department, though some of the measured performance is outside of the control of the manager - changes in the credit granted to customers will alter the average collection period, irrespective of the collection efforts applied to customers.
Related AccountingTools Courses
Credit and Collection Guidebook
Example of the Average Collection Period
A company has average accounts receivable of $1,000,000 and annual sales of $6,000,000. The calculation of its average collection period is as follows:
$1,000,000 Average receivables ÷ ($6,000,000 Sales ÷ 365 days)
= 60.8 Average days to collect receivables
How to Interpret an Increased Average Collection Period
An increase in the average collection period can be indicative of any of the conditions noted below, relating to looser credit policy, a worsening economy, and reduced collection efforts. The issues are as follows:
Loose credit policy. Management has decided to grant more credit to customers, perhaps in an effort to increase sales. This may also mean that certain customers are being allowed a longer period of time before they must pay for outstanding invoices. This is especially common when a small business wants to sell to a large retail chain, which can promise a large sales boost in exchange for long payment terms. In short, looser credit can be a tactical step to increase sales, or is a response to pressure from important customers.
Worsening economy. 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.
Reduced collection efforts. There may be a decline in the funding for the collections department or an increase in the staff turnover of this department. In either case, less attention is paid to collections, resulting in an increase in the amount of receivables outstanding. This is entirely an internal issue for which management is responsible, and so can be corrected through management action.
How to Interpret a Decreased Average Collection Period
A decrease in the average collection period can be indicative of any of the conditions noted below, relating to tighter credit policy, the imposition of shorter payment terms on customers, and a more active collections department. These issues are as follows:
Tighter credit policy. Management may restrict the granting of credit to customers for a number of reasons, such as in anticipation of a decline in economic conditions or not having enough working capital to support the current level of accounts receivable. This will shorten the average collection period, but will also likely reduce sales, as some customers take their business elsewhere.
Reduced terms. The company may have imposed shorter payment terms on its customers. As was the case with a tighter credit policy, this will also reduce sales, as some customers shift their purchases to more amenable sellers.
Increased collection efforts. Management may have decided to increase the staffing and technology support of the collections department, which should result in a reduction in the amount of overdue accounts receivable. It is cost-effective to continue adding staff to the collections department, as long as each incremental dollar for more staffing causes a correspondingly greater reduction in the amount of bad debt incurred.
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