The average collection period, also known as days sales outstanding, is a crucial metric that indicates how long it takes for a company to collect payment after extending credit to customers. This period reflects the efficiency of a company's credit policies and cash flow management. A shorter average collection period is generally preferred, as it signifies that the company is able to collect its receivables quickly, thus minimizing the time that cash is tied up in accounts receivable.
To calculate the average collection period, one must first determine the accounts receivable (AR) turnover ratio. This ratio is calculated using the formula:
AR Turnover Ratio = \(\frac{\text{Net Credit Sales}}{\text{Average Accounts Receivable}}\)
To find the average accounts receivable, the formula is:
Average Accounts Receivable = \(\frac{\text{Beginning AR} + \text{Ending AR}}{2}\)
Once the AR turnover ratio is established, the average collection period can be calculated using the following formula:
Average Collection Period = \(\frac{365}{\text{AR Turnover Ratio}}\)
This two-step process allows businesses to assess how many days, on average, a dollar remains in accounts receivable before it is collected. For instance, if a company has net sales of $500,000 and an average accounts receivable balance of $50,000, the AR turnover ratio would be 10. Consequently, the average collection period would be:
Average Collection Period = \(\frac{365}{10} \approx 37\) days.
This result indicates that, on average, it takes the company 37 days to collect payment from its customers after a sale. To evaluate the effectiveness of this collection period, companies often engage in benchmarking against competitors or industry standards. A lower average collection period is indicative of efficient credit management and cash flow practices, while a higher period may suggest potential issues in collecting receivables.
