Last Updated on May 16, 2022
Essential to any business is having customers pay invoices as quickly as possible, at least within the period allowed. The Average Collection Period ratio is a metric that can help determine how efficiently this is happening. Monitoring this metric can help a business determine if they have a collection problem than needs to be addressed.
Here’s everything you need to know about the Average Collection Period ratio, including how to measure it and what it means for your business.
What Is the Average Collection Period Ratio?
The Average Collection Period ratio is the average amount of time it takes for a business to collect its receivables. In other words, it tells you the average number of days it takes for clients to pay their invoices or, more importantly, how long it takes to get cash for your outstanding accounts receivables.
Who Uses the Average Collection Period Ratio?
If your company relies heavily on receivables for cash flow, the Average Collection Period ratio is an important metric. It can help determine whether enough cash is on hand to meet financial obligations. It is also an indicator of the effectiveness of the accounts receivable policy and whether it needs to be updated.
How Do You Calculate the Average Collection Period Ratio?
To calculate the Average Collection Period ratio, you will need a few data points:
- Days in Period: This can be any number of days, but most beneficial based on the number of days in the company’s credit policy that clients have to pay invoices.
- Average Accounts Receivable: Use income statements to determine the total accounts receivables at the beginning and end of the collection period, add the two figures together, and divide that number in half.
- Net Credit Sales: Refer to the balance sheet to get a total of all credit receivables and total returns for the period and then subtract the two figures.
Once you have gathered the necessary data, use the following formula to calculate the Average Collection Period ratio:
(Days in Period X Average Accounts Receivable) ÷ Net Credit Sales = Average Collection Period Ratio
How Do Businesses Use the Average Collection Period Ratio Calculation?
There are three ways to use the Average Collection Period ratio to monitor the efficiency of accounts receivables collections. You can compare the ratio to previous years’ ratios, compare it to your current collection terms, or compare it to competitors’ terms.
Compared to Current Credit Terms
By comparing the Average Collection Period ratio to the number of days in your current credit terms, you can easily see, on average, if you are collecting receivables sooner than your credit period allows or longer.
For example, if your company allows clients 30-day credit, and the average collection period is 40 days, that is a problem. However, an average collection period of 25 days means you are collecting most accounts receivables before the end of the 30 days.
Compared to Previous Years’ Ratios
Comparing the current Average Collection Period ratio to previous years’ ratios shows whether collections improve or worsen over time.
If your current ratio is lower now than it was previously, it means, on average, that your company is collecting receivables in fewer days than before. Conversely, a higher ratio means it now takes longer to collect receivables and could indicate a problem.
Compared to Competitors’ Ratios
The Average Collection Period ratio can also be compared to competitors’ ratios, either individually or grouped. It can be used as a benchmark to determine if you might need to tighten or loosen your credit policy relative to what the competition might be offering in terms of credit.
What Are the Limitations of Using the Average Collection Period Ratio?
The average collection period ratio is limited in that it does not have much meaning on its own. However, comparing it to previous years’ ratios or the credit terms of your company will provide you with meaningful data that can indicate whether you have an accounts receivable problem or not.
The Bottom Line
The Average Collection Period ratio is an essential metric for businesses that rely on receivables for cash flow. If clients are taking too long to pay invoices, a company may not always have the necessary cash on hand to operate the business and meet financial obligations.
A ratio higher than your current credit terms period might require changing your credit policy, including shortening the payment period or outlining the payment terms more clearly to clients. A very low ratio may indicate that your company’s credit terms are too strict. You could be losing business to competitors with more lenient payment terms.
Grey was previously the Director of Marketing for altLINE by The Southern Bank. With 10 years’ experience in digital marketing, content creation and small business operations, he helped businesses find the information they needed to make informed decisions about invoice factoring and A/R financing.