Average Collection Period

Average Collection Period

The average collection period measures how long, on average, it takes a business to collect payments on credit sales. It’s a key indicator of accounts receivable (AR) management and short-term liquidity: shorter collection periods generally mean faster cash inflows, while longer periods can strain cash flow and signal credit risk.

Why it matters

• Shows how quickly receivables convert to cash.
• Reflects how strict or lenient credit terms are.
• Helps benchmark performance against competitors or industry norms.
• Signals increasing credit risk when the period lengthens.
• Informs cash flow planning and working capital management.

How to calculate it

Two common formulas:

1) Using average accounts receivable and net credit sales:
Average collection period = 365 × (Average accounts receivable ÷ Net credit sales)

2) Using the receivables turnover ratio:
Average collection period = 365 ÷ Receivables turnover ratio

Notes:
– Average accounts receivable is typically (Beginning AR + Ending AR) ÷ 2. More precise methods use daily balances.
– Net credit sales exclude cash sales and adjust for returns, discounts, and allowances.
– Use the same period for AR balances and net credit sales (e.g., full-year sales with beginning/ending AR for that year).
– Consider seasonality; peak vs. slow months can skew averages.

Interpreting the result

• Lower number = faster collections, better liquidity.
• Very low number may indicate overly strict credit terms that deter customers.
• Compare the period to your stated credit terms (e.g., net 30). If average collection ≈ 25 days for net 30, collections are on track; if it’s 45 days, customers are paying late.
• Compare against peers or historical trends to spot deterioration or improvement.

Example

If average AR = $10,000 and net credit sales = $100,000 for the year:
Average collection period = 365 × ($10,000 ÷ $100,000) = 365 × 0.1 = 36.5 days

Receivables turnover = Net credit sales ÷ Average AR = $100,000 ÷ $10,000 = 10
Average collection period = 365 ÷ 10 = 36.5 days (same result)

Industry differences

Different industries have different typical collection cycles:
– Banking and lending: closely managed receivables due to loan/mortgage income reliance.
– Real estate and construction: longer cycles are common because projects and billing are intermittent.
– Retail and consumer services: tend to have shorter collection periods, often supported by cash sales or tight terms.

How to improve the average collection period

• Tighten credit policies: stricter qualification for credit customers.
• Align terms and enforcement: ensure invoicing and due dates match policy and follow up promptly.
• Offer discounts for early payment (e.g., 2%/10 days).
• Automate invoicing and reminders; accept electronic payments.
• Monitor receivable aging and pursue overdue accounts proactively.
• Limit credit exposure to high-risk customers or require deposits/milestones for long-term projects.

Bottom line

The average collection period is a simple but powerful metric for managing cash flow and credit policies. Regularly calculate and track it against internal targets, industry benchmarks, and stated credit terms to maintain healthy liquidity and minimize credit risk.