Many modern businesses offer their customers the option to sell on credit. A “buy now, pay later” model should theoretically increase sales. The downside to offering delayed payment is that cash flow can be uncertain. It becomes more difficult to finance day-to-day operations or make future investments if too many customers have delinquent accounts. One way to measure the success of a creditor company’s collection success is the average collection period.
Calculating the Average Collection Period
The average collection period is a simple accounting metric. It represents the average number of days it takes to turn credit sales into actual cash. The standard formula is calculated by dividing the current accounts receivable balance by the average daily sales.
Average daily sales is equal to total annual sales divided by 360, although these figures can be adjusted to track quarterly or monthly performance. Companies with proportionately larger credit sales, such as online retailers or auto dealers, typically have higher average collection periods.
An alternative means of calculating average collection period is to multiply the total number of days in the period, such as 360 for an annual period, by the average balance in accounts receivable. That figure is divided by net credit sales during the same period. This method is useful for comparing companies with different proportions of credit sales.
Cash Flow and Average Collection Period
The average collection period is used a couple of different ways to measure cash flow performance. Most creditors create forecasts about how different accounts receivable periods might change investment in receivables. Companies that invest less in accounts receivable are able to improve other cash outflow performances.
Generally speaking, companies want to minimize their average collection periods. This frees up more cash for added liquidity, better solvency ratios and more investment. Creditors frequently examine their accounts receivable aging to see if their collection periods are too long.