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Definition

Average Collection Period

What is the Average Collection Period?

The Average Collection Period is how long it takes a business to gather its receivables. Put another way, it provides an estimated time for a company to take payment from buyers or consumers. This collection period should be tracked to ensure that a business or organization has adequate cash on hand to meet its short-term financial commitments.

Understanding of Average Collection Period

Accounts receivable (AR) is a financial concept that refers to money owed to a corporation through those people who have purchased goods or services. These sales are typically made to consumers on credit. It is a liquidity ratio represented as current assets on a company's balance sheet. As a result, they show that they can pay off existing short-term loans without relying on further income flows. 

This collection period is a measurement used to calculate the average number of days between the date of sale and the date of payment. A company’s average collection period indicates the effectiveness of its management that deals with the accounts receivable department. Businesses must keep a close eye on their collection period so that they do not run out of capital.

This period is an accounting indicator that represents the average length of time between the date of a credit sale and the date of payment by the customer. The success of an industry's AR management methods is measured by its average collection period. Companies must be able to handle their typical collecting period to function properly.

Formula

Here is the formula to calculate this particular period-

Average Collection Period = (Average Receivables ÷ Total Net Sale) × 365

In general, a shorter average collecting time is preferable to a longer one. A short collection period shows that the company receives money quickly. However, this has a disadvantage in that it may indicate that the firm’s credit requirements are excessively severe. For example, consumers dissatisfied with their creditors' conditions may look for manufacturers or service providers with more flexible payment terms.

Practical Example

A company named JK's year-end account receivable balance is $21,000. Its entire net revenues during this period were $200,000. Now, we can use the collection period formula to calculate JK's period:

Average Collection Period = ($21,000 ÷ $200,000) × 365 = 38.3

This collection period on average is 38.3 days. Given that most businesses collect their receivables within 30 days’ time, JK is doing pretty well. Collecting receivables in a manageable timeframe allows the company to pay off its current liabilities.

If any firm's typical collection duration is greater than 60 days, it would have to implement a much more active collection procedure to reduce that timescale. Or else, it may find itself unable to meet its debt obligations.

In Sentences

  • Average collection period refers to a financial term used to calculate the period a firm or company or organization needs to gather its account receivables.

 

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