The importance of metrics for your accounts receivable and collections management isn’t lost on you. You need a measuring stick to determine exactly how effective your efforts are.
Accounts receivable metrics can tell you. There are plenty of metrics to choose from, of course, so you must select those you measure wisely. You’re already measuring your accounts receivable turnover ratio. Now you’re wondering about your average collection period ratio.
What Is It?
The average collection period ratio is closely related to your accounts receivable turnover ratio. While the turnover ratio tells you how often you collect your accounts, the collection period ratio tells you how long it takes you to collect accounts.
Using this calculation, you can discover how long it takes to collect from the time the invoice is issued to the time you get paid. If the average is low, it’s good. You collect accounts relatively quickly. If the number is on the high side, you could be having trouble collecting your accounts. A high average collection period ratio could indicate trouble with your cash flows.
The Numbers You Need
Now you want to go about calculating your average collection period ratio. Are you collecting accounts in a timely manner, or is this something your team needs to work on?
To calculate this ratio, you’ll need to gather up a few numbers. The first thing to decide is the time period you want to calculate the average for. Many accountants will use a one-year period (365 days), or an accounting year (360 days). You can also calculate the ratio for shorter periods, such as a single month.
Next, you’ll need to calculate the average accounts receivable for the period. Find this number by totaling the accounts receivable at the start and at the end of the period. Divide this number by two to find the average.
Finally, you need the net credit sales for the period. This number is the total number of credit sales for the period, less payments you received.
Doing the Math
Once you have these numbers in hand, you’re ready to calculate the average collection period ratio.
The calculation itself is relatively simple. First, multiply the average accounts receivable by the number of days in the period. Divide the sum by the net credit sales. The resulting number is the average number of days it takes you to collect an account.
The formula looks like this:
Days x Average Accounts Receivable / Net Credit Sales = Average Collection Period Ratio
Sometimes, it’s best to work through a practical example. Suppose Company A’s leadership wants to determine the average collection period ratio for the last fiscal year. Their period is 365 days.
They opened last year with $43,000 in accounts receivable. They closed the year with $61,000. The total for the period is $104,000. The average is $52,000, as the total is divided by two.
Net credit sales were $500,000. Now Company A has all of the information it needs to calculate the ratio.
They’ll multiple 365 days by $52,000, to get $18,980,000. Next, they’ll divide this number over $500,000, the net credit sales. This gives them 37.96, meaning it takes them, on average, almost 38 days to collect accounts.
What It Means
Company A is likely having some trouble collecting accounts. Most businesses require invoices to be paid in about 30 days, so Company A’s average of 38 days means accounts are often overdue. A lower average, say around 26 days, would indicate collection is efficient and effective.
Of course, the average collection period ratio is an average. You likely collect some accounts much faster, while others remain overdue longer than average. Nonetheless, the ratio can give insight into how efficient your accounts receivable process is—and where you need to improve it.