Keeping tabs on your business’ performance across all sectors is a good idea. It’s why you’re measuring statistics designed to keep you informed about how well you’re doing and where you need to improve.
One area you’re keeping an eye on is your accounts receivable management. After all, collecting accounts is the backbone of most companies. If you don’t collect, you don’t get paid!
There are a number of measurements to determine how well your accounts receivable team is performing, including the accounts receivable turnover ratio. You might be monitoring that stat, but are you looking at the average collection period ratio too? You should be.
What Is It?
The average collection period ratio is a measurement closely related to the accounts receivable turnover ratio. Unlike the turnover ratio, this measure tells you not how often you collect accounts but how long it takes you to collect them, on average.
In fact, some people refer to this statistic as the “average collection period.” The number tells you the average number of days it takes to turn an invoice into cash.
How Is It Calculated?
The calculations for the average collection period ratio are fairly simple, which is another reason to use this statistic. It’s effective and easy to get your hands on.
To find your average collection period ratio, do the following.
First, determine the length of time you want to calculate the ratio for. This can be a year (365 days), the typical accounting year (360 days), or even just a month-to-month calculation. Make sure the data you’re using for your accounts data matches the timeframe you select, however.
Once you’ve determined the number of days, collect the account information, including average accounts receivable and net credit sales, for the same time period. Total your accounts receivable from the beginning of the period and the end of the period. Divide the result by two.
Net credit sales are the total credit sales less the returns (the accounts paid) over the same period.
Sometimes, it’s easier to understand how to perform a calculation with an example. Suppose your company is calculating your average collection period ratio for the last fiscal year. Your period is 365 days. At the beginning of the year, your accounts receivable were $42,000, and at the end, $60,000.
Add these two numbers together for a total of $102,000. Dividing this by two, you find the average accounts receivable over the period: $51,000.
Now multiply the average by 365 days. Take this number and divide it by your net credit sales. The result will be your average collection period ratio. If your net credit sales were $700,000 for the year, then your average collection period ratio would be about 26 or 27 days.
What Does It Mean?
The average collection period ratio means, on average, it takes your customers about 26 or 27 days to pay their bills. If your terms of payment are 30 days, you have a decent turnaround, although customers could certainly pay you faster. Some customers likely do! There are also those who don’t pay you so promptly.
The number is, of course, an average. Some customers pay sooner while others take longer. On the whole, most of your accounts will be paid within this window.
Why is it useful to know this? You can begin to think about how to incentivize your customers to pay even sooner. It also lets you know if you’re doing a good job at collecting accounts or if, on average, your customers are late with payment. You might then investigate why.
In short, this is a great metric to keep an eye on when it comes to measuring your accounts receivable management performance.