Average Collection Period

The time taken by a company to collect the account receivables (AR) from its customers

Is the time taken by a company to collect the account receivables (AR) from its customers. More specifically, it shows how long it takes a company to receive payments made on credit sales.

What is the average collection period?

This is critical for cash-reliant businesses such as: 

  • Convenient stores
  • Nail salons
  • Food trucks
  • Laundromats
  • Small restaurants/local bars
  • Delivery services
  • Gift shop
  • Tutoring services
  • Carpenter

These types of businesses rely on customers to pay in cash to ensure that they have enough liquidity to pay off their suppliers, lenders, employees, and other trade payables. 

When businesses rely on a few large customers, they take on the risk of a delay in payment. This can lead to financial difficulties and closing down their business in the worst case. 

As a result, keeping cash in hand has proven critical for smaller enterprises, as it allows them to pay off future debt and other financial obligations. To facilitate this, businesses often arrange credit terms with suppliers and customers. 

These credit terms can range from 30 to 90 days, depending on the business's track record and financial needs. 

Suppliers can assist small businesses by setting favorable credit terms with them; the arrangement can allow businesses to receive their stock and pay later, which will be recorded as a trade payable on the balance sheet

Similarly, businesses allow customers to pay at a later date; this is recorded as trade receivables on the business's balance sheet. 

Lastly, the average collection period is a metric to evaluate the current credit arrangements and whether changes should be made to improve the working capital cycle.

Average collection period formula

Formula

 

Formula

* if total net credit sales are not stated in your financial statements, a general rule is to use total net sales

Example

ABC is a manufacturing company. Its operations are dependent on the cash inflow from buyers. It currently has an average account receivable of $250,000 and net credit sales of $600,000 over 365 days. ABC wants to know what their average collection period is. 

By using the formula above, we can calculate this indicator as: 

($250,000 ÷ $600,000) × 365

The result would be 152.08 days. So, what does this number mean? Well, a company should think about two things:

  • What is the current credit collection policy? 
    • Suppose ABC company has a credit policy of 120 days, and their average collection duration is 152.08 days. This may suggest that it should implement a stricter credit policy to ensure that all credit payments are collected on time. This will help avoid bad debts, which affect the cash flow statement.
  • What are the industry benchmarks?
    • Suppose ABC's competitors have a more extended average collection period. In that case, ABC may wish to consider loosening its credit policy to offer a more flexible payment term. This will help attract more customers as it may be a differentiating factor.

This example shows how a company can utilize the average collection period to compare its credit policy to industry norms, internal monitoring, and standards.

The importance of average collection period 

It is critical for any business to track this metric because it gives insight into the business's financial health, credit terms, and cash flow cycle. 

Without this, predicting future cash flows, demand, and liquidity of the business will be tough; therefore, planning expenses and investments will be a relatively complex task. 

Its importance

For example, ABC wants to open up a new plant to expand its business operations, including expenses such as market research, licensing, labor costs, and other overhead costs. 

ABC will need to know the cash inflow from its account receivables and other sources to plan its expenses/investments in advance. 

For this reason, companies that have high credit sales will want to focus on the following aspects: 

  • Maintaining liquidity
    • Liquidity is the ability of a firm to raise cash when it needs it. Receiving payments for goods and services on time plays a big part in maintaining liquidity. This enables companies to pay off short-term liabilities such as bills and trade payables. It also helps to track the financial health of the business.
  • Planning ahead 
    • The average collection period figure allows a company to plan effectively for forthcoming costs. This can come in the form of securing a loan to acquire more long-term assets for expansion. It can also help to predict any cash flow disruptions. The goal for most companies is to find the right balance in their credit policy. This should be fair and accommodating to customers while efficient and realistic to the firm. 

How Has COVID-19 Impacted the Average Collection Period? 

COVID-19 has further highlighted the importance of the average collection period. In 2020 alone, more than 340 companies in the US filed for bankruptcy, with well-known names such as J.CrewHertzGuitar Center, and Mallinckrodt

Vaccines-covid-19

This is because many firms face the following financial challenges: 

  • Cash flow strains
  • Insufficient liquidity
  • Delayed payments
  • Default on payments
  • Shutting down their business
  • File for bankruptcy

These issues have pushed businesses to further streamline their accounts receivable process by implementing several key metrics and procedures to maintain liquidity.

  1. Proactive communication: Businesses are also encouraged to step up their invoicing efforts, which are done digitally, post or with new payment methods to remind customers to pay on time.
  2. Convenience: The payment processes should be as seamless as possible to make it easy for customers to pay. For example, if most of the customer base pays through digital payment methods, your repayment procedure should be initiated online instead of going to the store with cash. 
  3. Prioritize: The pandemic has caused a lot of chaos in businesses' day-to-day operations. Businesses can often forget or sideline collection activities. Therefore, it is essential fulfilling critical accounts by establishing a dedicated team for this task or finding a collections agency. 
  4. Using analytics to assess your accounts receivable portfolio: The AR portfolio will vary depending on each business. But as a general format, businesses can split accounts into a three-tier system of good, fair, and poor. This will help identify which accounts are more likely to repay and those that are likely to default. 

Average Collection period by industry

Depending on the industry, this metric will vary. For instance, some industries are notoriously known for a high average accounts receivable day, such as the following: 

  • Management companies
  • Oil companies
  • Gas companies
  • Technical and trade schools
  • Auto rental and leasing companies 
  • Engineering companies
  • Architectural firms
  • Outpatient care centers

Tools

In contrast, privately held firms and tech firms have a shorter collection period of 30 to 40 days. To give a better understanding of the diversity in the collection period, we will look at the following industries: 

1. Agriculture and forestry: This industry will have a slightly longer collection period because the relationship between the supplier and buyer is built on mutual trust. 

  • The seasonality of agricultural and forestry goods is typically sold in bulk to the government or large merchants.
  • Because these are often trusted agencies with contracts and existing partnership arrangements, it can help to reduce the risk of a longer collection period. 

2. Construction and real estate: This industry will emphasize shorter collection periods because real estate frequently requires ongoing financial flow to support its operations. 

  • For example, a large expense will be purchasing materials and employing labor. This will be reimbursed once the buildings are completed and provide a consistent flow of income.  

3. Medical and healthcare: Collecting payments in this industry is challenging. 

  • This is because payments are handled through third parties, such as insurance. Insurance companies will need to do a thorough investigation to authorize payments which can take a long time. 
  • Therefore, healthcare providers frequently need to stay on top of collections to guarantee that they can continue to give free treatments to non-paying customers.

Is It Better to Have a Low or High Collection Period?

Generally, having a low average collection period is preferable since it indicates that the firm can collect its accounts receivables more efficiently. 

A high collection period may indicate: 

  • Loose credit policy - loosening credit policy can increase sales effort. This occurs when small businesses deal with larger retailers to secure long-term partnerships to boost sales. However, this is also due to a lack of bargaining power.  
  • Worsening economy - this may lead to delayed payments as customers' cash flows are impacted.
  • Reduced collection efforts - less attention is being paid to accounts receivables due to a decline in efficiency in the funding and collections department or a high staff turnover in this department.  

A low collection period may indicate: 

  • Tighter credit policy - as a result of factors such as economic downturn anticipation, reduced working capital, and changes in competitors' credit policies
  • Shorter payment terms - imposing shorter payment terms help to increase sales efforts by retaining and attracting customers.
  • Increased collection efforts - dedicating a team or sourcing externally to collect outstanding debt and repayments.  

However, as previously noted, there are repercussions to a very short collection time, such as losing customers to clients who have a more lenient collection period. 

As a result, it is best to compare the outcomes to industry standards and other competitors as they may vary depending on the company's sector. 

It will also be helpful for businesses to compare the average collection period with other key performance indicators (KPIs) such as Days Sales Outstanding (DSO), Collector Effective Index (CEI)Profit Per Account (PPA), and past performance to get a clearer picture of what this figure indicates.

Did you know that 49% of B2B invoices in America are overdue? 

Best Practices 

Integrating best practices into the collections department and team can help to improve collection efficiency.
 

Best Practices

Some practices that a company can implement are as follows:

  • Companies should aim for a 95%-99% collection rate percentage.
  • Establishing a target range for AR will assist in reducing collection periods.
  • An appropriate performance measure would be to have no more than 15 to 20% of total AR in more than 90 days.
  • Outline clear billing procedures to make it easier for customers to pay.
  • Creating a clear internal communications system and processing invoices to track down repayments more efficiently.
  • Working with mailed payments, such as post office box partnerships, lockbox banking, pre-authorized checks, and pre-authorized debits.
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Researched and authored by Freida Lee | LinkedIn

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