How to calculate average collection period for accounts receivable?
Finance professionals weigh multiple factors to determine the average performance of their company. One of the important factors that highlight turnover and cash flow management is the average collection period.
This value is based on how quickly you collect payments from your customers. Average collection period analysis can throw light on many takeaways that will help you understand your company more.
Many accounts receivable teams often stumble on how to calculate average collection period and what to make of it.
What is average collection period?
A business needs cash to run — and that comes from the money it collects from customers. Business customers take time to return the payments.
This can potentially impact the cash flow of the business, leaving it with more or no money. One factor in deciding the liquidity flow of the business is the average collection period.
The average collection period is the average value of the duration when a business collects its payments from its customers.
The lesser the score is, the quicker you get the money in your account and vice versa. Ideally, the score must be low for you to run your business without financial hindrances.
Importance of calculating average collection period
The average collection period for account receivables can help you with future financial planning. Here is how the calculation of average collection period plays a role in your accounts receivable.
Plan for future costs
When you know the current balance of your account, you can schedule and plan your future expenses accordingly. While seeking payments and retaining customers, one can easily miss out on timings.
Receiving early payments is essential to plan your financial forecasts the right way and adhere to budgets accurately. But you cannot pressure your customers to pay instantly too.
Average collection period analysis is needed here to know where you stand. You can tune your collection periods accordingly and align accounts receivables in order.
A little tuning is always needed as a lower collection period can leave some customers dissatisfied. Expecting to pay quicker might appear like a stringent rule and push them to find alternative providers.
Helps maintain & monitor liquidity
Liquidity is a financial measure of how instantly you can access cash for business expenses. No matter how strong your budgets are, unexpected expenses can make their way through.
Maintaining a proper average collection period is the way to receive payments on time and keep them at your disposal. If you lose sight of that, the accounts receivables can get out of hand anytime, leading to funds scarcity.
Understand creditworthiness
When you are selling products on a credit basis, you should weigh if the buyers are eligible to repay on time. For better client management, looking deeper into clients’ creditworthiness is important.
Unless you run a finance-based business, accessing their financial statements is not possible for you. Yet, with the calculation of average collection period, you can predict and understand their creditworthiness.
Gain insights
The average collection period for account receivables tells you which client pays earlier and which prolongs dues. Knowing their payment patterns, you can modify and effectuate your communication with them and follow-up messages.
Your business is at risk when the average collection period score is constantly high. Not every client coordinates when they struggle to pay fully every time. It’s better to let them go instead of being taken for granted.
Closely monitor your business’s financial performance
Monitoring your financial health is important to maintain a positive cash flow and sustain growth. The average collection period will tell you what your financial health looks like in the near future.
You know the problematic areas, and by taking action, you can steer clear of financial hindrances around the corner.
How to calculate average collection period?
In specific terms, the average collection period denotes the days between when a customer buys the product and makes the full payment.
The output value is in days. There is a formula to calculate average collection period.
Before starting this, the accounts receivable team should estimate the total collection made for the year and the total net sale amount (the amount they might have made with sales throughout the year).
Average collection period = (accounts receivable balance / Total sales) * 365
To explain this better, let’s take a look at the hypothetical case of a company, ‘XYZ’. By selling their product, they would have collected $ 50,000. But they only managed to collect $ 10,000, which is their accounts receivable balance.
Their average collection period = 10000/50000 * 365 = 0.2 * 365 = 73
73 is a very high score. Most companies try to clear their outstanding accounts payable within a month. In this case, the clients of XYZ take more than two months to repay the sale amount.
This is a threat as the company will always be behind and never have needed funds in stock to achieve its plans.
How to shorten your average collection period?
If you discover shockingly high values when you calculate average collection period, you must work on ways to reduce them. Here are the ways to shorten the collection period without losing customers.
1. Analyze and optimize cash flow
Cash flow decides each step you take in your business. In a month, there will be both high and dropping low points for the cash flow. Analyze it better and optimize your accounts payable based on that.
Schedule your large payments on days when the cash flow is looking up. Adjust your accounts receivable in line with this process and strategically manage both payment sections.
2. Offer discounts
Discounts are always an enticing opportunity to increase sales and encourage customers to pay. You can strategize your discount campaigns based on repayment terms.
For example, customers who pay within 15 days from the purchase date can make use of a 10% discount. Or alternatively, you can penalize late payers with a significant late charge.
3. Shortening bank processing time
Certain payment methods take a longer time to process and clear payments. If you are accepting checks, it can take two to three business days to collect the money. Similarly, banks delay payments by a few hours or a day.
When customers take their steps to make payments, waiting for processing time to end is not good for both. With the help of modern payment systems, you can rule this time out.
4. Enforce collection policies
Go through your client and repayment policies and look for gaps. Customers can often misunderstand the terms or use unclear statements in their favor.
Enforce strict payment terms and communicate the same with your current and future customers. Look at the average collection period analysis and reduce the collection time.
5. Streamline customer invoicing
Send invoices automatically on time to receive payments on time. There are automated software that streamlines invoicing sending process.
You can receive payments quickly and send reminders without putting any effort. Let your accounts receivable team put more effort into accepting payments on time.
Related read - 6 reasons to automate accounts receivable process
Run an average collection period analysis frequently
The average collection period for accounts receivable does more good if done frequently and properly. Frequently conducting an average collection period analysis is important to ideate your collections strategy and improve liquidity.
Every year, more than 40% of small businesses fail due to insufficient funds and cash flow problems.
Learning how to calculate average collection period will help your accounts receivables team to find where they stand and take action to shorten their score.
FAQs
Anything lesser than 30 days is considered a good collection ratio.
When bill payments are delayed, your cash reserve will deteriorate, and you will have low or zero access to funds. Liquidity is the ability to access funds instantly. A higher average collection period strongly impacts liquidity.
15 to 30 days should be the average collection period for accounts receivable.
Days sales outstanding are the same as the average collection period. DSO is another term to refer average collection period.
Businesses mostly sell their products on a credit basis. The time they require to collect the money back from the customer is known as the accounts receivable collection period.