Nowadays, it is hard to imagine a business that does not sell on credit and, accordingly, deals with accounts receivable. Although there are many advantages to it, every company should closely watch this element of their business and use various measurements to keep it under control.
The average collection period is typically considered as the number of days that usually pass before the customer pays for the goods and the entity is able to collect its money from sales. This financial indicator should be paid attention to by organizations whose cash flows largely depend on the funds received from the credit sales.
The entity should occasionally review its collection time to see if it is at an acceptable level. Management can check how the average collection period stacks up against the standard number of days for repayment granted to customers. Based on the results, the appropriate measures can be taken to help the company better manage this crucial part of its business.
In most cases, management and investors are looking for a shorter time frame. A short period indicates that the customers make payments shortly after making the purchase. If the number is comparatively high, it may point towards an inefficient accounts receivable collection function at a particular company, which can negatively affect its overall success. There are several measures a company can take to control accounts receivable:
- Offer discounts to prompt settlement
- Give a choice of payment methods
- Send invoices as soon as possible
- Remind customers about payments due as well as late payments
- Create a penalty policy and charge overdue fees
- Reduce credit limits
- Know when to call the collection agency.
At the same time, the management should keep in mind that if this period is very short, it might mean that its policies on credit sales are very strict. This can negatively affect its sales and lower the number of potential customers.
To get the average collection period for any entity, just input the numbers into the equation below.
To better illustrate how this formula works, let’s assume Rosie Dresses has a beginning balance in AR of $890,000, an ending balance of $780,0000, and annual sales of $2,650,000. Accordingly, the average AR will equal $890,000 plus $780,000 divided by two or $835,000.
To find how long it takes for Rosie Dresses to collect the money its customers need to pay for the goods already purchased, we will divide the annual sales of $2,650,000 by 365 to get $7,260. Now, we need to divide the number we got earlier by $7,260. After simple calculations, we get an average collection period of 115 days.
This means that it takes this company more than three months on average before it gets paid for the goods. After seeing this number, the management should create a more strict collection policy to cut this number at least in half. This will allow Rosie Dresses to have enough cash flow to pay its own debts and invest money into further development.