It refers to how quickly the customers who bought goods on credit can pay back the supplier. The earlier the supplier gets the funds, the better it is for business because this fund is a huge source of liquidity. It can set stricter credit terms limiting the number of days an invoice is allowed to be outstanding. This may also include limiting the number of clients it offers credit to in an effort to increase cash sales.
An organization that can collect payments faster or on time has strong collection practices and also has loyal customers. However, it also means that they follow a very strict collection procedure which may also drive away customers because they prefer suppliers who have more flexible credit terms. Businesses must decide whether they want to allow their customers to have the option to make purchases from them on credit. These decisions are based on many factors such as the industry norm, the value of credit sales to the business, the recoverability of the balances, etc. If a business chooses to only allow cash transactions, then it may lose customers that want to buy from the business on credit. Rationalising the receivables collection period is essential for businesses to streamline their cash flows, maintain healthy relationships with stakeholders, and ensure higher stability and business performance.
It is a critical metric used in financial analysis to assess the efficiency of a company’s credit and collection policies. The account receivable collection period of a business allows the business to evaluate its credit limits and policies. By calculating the receivable collection period, a business can determine how much time it takes for the business to recover its receivable balances. If the collection period is above the expected period, then the business will have to take steps to rectify it and ensure the chances of bad debts are reduced to a minimum.
Formula for Average Collection Period
However, if the shorter collection period is due to overly aggressive collection practices, it runs the risk of straining customer relationships, potentially leading to lost business. Average collection period, sometimes referred to as days sales outstanding, is the average time that elapses between your company’s completion of services and the collection of payment from your customers. Once we know the accounts receivable turnover ratio, we can do the average collection period ratio. It increases the cash inflow and proves the efficiency of company management in managing its clients.
How average collection period affects cash flow
Implementing an efficient and automated invoicing system can enhance accuracy and timeliness while reducing manual errors. Additionally, utilising online payment platforms and providing multiple payment options can facilitate faster and smoother transactions, reducing the collection period. To address an increasing collection period, companies can employ various strategies. First, they can review and strengthen their debtor collection period formula credit policies, ensuring that credit terms are clear, reasonable, and aligned with industry standards.
- We’ll use the ending A/R balance for our calculations here and assume the number of days in the period is 365 days.
- It may mean that the company isn’t as efficient as it needs to be when staying on top of collecting accounts receivable.
- The average collection period is the timea company’s receivables can be converted to cash.
- Then multiply the quotient by the total number of days during that specific period.
Analyze Payment Terms and Policies
For instance, consumers and businesses often face financial constraints during recessions or economic instability. Consequently, this may delay payments or lead to higher defaults on invoices — resulting in longer average collection periods as companies struggle to collect on outstanding receivables. Law firms, for example, reportedly saw an overall increase of 5% in the average collection cycle in 2023.
Example of Debtor Days
💡 To calculate the average value of receivables, sum the opening and closing balance of your required duration and divide it by 2. You can also open the Calculate average accounts receivable section of the calculator to find its value. As an alternative, the metric can also be calculated by dividing the number of days in a year by the company’s receivables turnover. The average collection period measures a company’s efficiency at converting its outstanding accounts receivable (A/R) into cash on hand. Let’s say that Company ABC recorded a yearly accounts receivable balance of $25,000.
If businesses only generate profits but fail to generate cash flows, they can face a lot of problems. Similarly, businesses also need to generate cash to pay other business expenses such as rents, utilities, repair and maintenance, etc. This means your company’s locking up less of its funds in accounts receivable, so the money can be used for other purposes. Additionally, a lower number reduces the risk of customer defaults and likely reflects that payments are being made on time, depending on your billing cycle. In today’s business landscape, it’s common for most organizations to offer credit to their customers. After all, very few companies can rely solely on cash transactions for all their sales.
