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.
The formula for the average collection period is:
For example, 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:
An increase in the average collection period can be indicative of any of the following conditions:
- Looser 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.
- Worsening economy. General economic conditions could be impacting customer cash flows, requiring them to delay payments to their suppliers.
- 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.
A decrease in the average collection period can be indicative of any of the following conditions:
- 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.
- Reduced terms. The company may have imposed shorter payment terms on its customers.
- 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.
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.
