Unpaid accounts receivable (AR) are a major contributor to cash flow issues for numerous businesses. As a result, a company’s spending power may become significantly constrained or completely exhausted. Ensuring a healthy cash flow is essential for every business’s prosperity, which necessitates effective accounts receivable management.
Efficient AR management involves diligently monitoring crucial metrics, specifically the accounts receivable collection period. This critical metric calculates the time required to collect your AR, offering insights into whether the average duration is suitable for your business.
If you’re interested in understanding the accounts receivable collection period, its significance, the accounts receivable collection period formula, and how to compute your own, this article is tailored for you.
What Is Accounts Receivable Collection Period?
The average collection period for accounts receivable is the number of days, on average, that a business takes to collect payments on outstanding AR. This metric demonstrates the duration before customers settle their unpaid invoices, commencing from the credit sale date.
Numerous businesses depend on credit sales to attract and maintain clients. These businesses anticipate receiving payment on a pre-established date, while the unsettled credit sale is recorded as accounts receivable.
Understanding the receivables collection period can offer insights into your business’s future cash flow projections. This metric allows you to assess your liquidity, ensuring sufficient incoming cash to cover daily necessities and more.
A low AR collection period signifies that your business is collecting payments more rapidly, whereas a higher value suggests that your collection efficiency may require improvement.
In either case, the average collection period of accounts receivable serves as a direct indicator of your business’s overall effectiveness in managing its AR.
How Average Collection Period for Accounts Receivable Works
Accounts receivable (AR) is the money owed to a company by customers who have purchased goods or services on credit. Listed as current assets on a company’s balance sheet, AR demonstrates liquidity, reflecting the capacity to settle short-term debts without depending on additional cash inflows.
The AR collection process involves the accounts receivable collection period, an accounting metric that signifies the average number of days between a credit sale and the date of the customer’s payment.
The average collection period for accounts receivable acts as a gauge of the effectiveness of a company’s AR management practices. Proper management of the AR collection period is crucial for smooth business operations.
A lower accounts receivable collection period is typically more desirable, as it indicates the company’s ability to collect payments more rapidly. However, this may also suggest that the company’s credit terms are excessively stringent, potentially causing customers to seek suppliers or service providers with more accommodating payment terms.
Consequently, businesses must find a balance in their AR collection practices to preserve customer satisfaction while securing timely payment collection.
The accounts receivable collection period formula is essential for determining the AR collection period and understanding how efficiently a company manages its receivables. By closely monitoring this metric, businesses can optimize their AR management and improve cash flow.
The Importance of Calculating Your AR Collection Period
For businesses that offer credit sales, it’s crucial to ensure swift payment collection. While credit sales contribute to revenue, they do not immediately result in cash inflow. Prompt customer payments lead to increased cash availability for your business.
A lower collection period for accounts receivable typically signifies a healthier financial situation for your company, as it directly affects cash on hand or in the bank. One of the key performance indicators (KPIs) for your cash management team in achieving liquidity objectives is reducing the receivables collection period.
In simple terms, maintaining an optimal AR collection period enables your business to have a greater potential for growth.
The accounts receivable collection period formula plays a significant role in determining the efficiency of your company’s AR management. By closely monitoring this metric, businesses can enhance their cash flow and ensure a more robust financial standing.
How to Calculate Accounts Receivable Collection Period
Your business’s AR collection period is calculated by dividing your accounts receivable turnover ratio for a given period, typically a year, by the number of days in that same period.
Companies often assess their AR collection period annually. The “days” in the equation refer to the number of days in the period being calculated, which, as mentioned, is typically one year. The “receivables turnover” at the bottom is calculated using another data set.
Calculating Accounts Receivable Turnover Ratio
To come up with your average AR collection period over a specific timeframe, you’ll need to calculate the receivables turnover.
The accounts receivable turnover formula is as follows:
Accounts Receivable Turnover Ratio = Net Credit Sales : Average Accounts Turnover
Computing your accounts receivable turnover ratio requires gathering your net credit sales and the average accounts receivable balance during the period. You then need to get the ratio of your net credit sales over the average accounts receivable balance. Let’s look at these two variables in more detail.
Net Credit Sales
Your company’s net credit sales are the total revenue it made on credit fewer sales returns and allowances over the period.
All sales made on credit are non-cash transactions your customers must pay later, accruing as accounts receivable. Sales returns and allowances are reductions in prices resulting from issues with the sales transactions, such as when a company underdelivers their goods.
Net Credit Sales = Gross Credit Sales – Returns – Discounts – Allowances
Average Accounts Receivable Balance
Getting your company’s average accounts receivable balance is a matter of looking at your balance sheet’s AR entry for each month’s end and getting the average of the last 12 months (if you’re going after an annual period).
After getting your net credit sales and average AR balance, it’s time to calculate your receivables turnover. Simply use the accounts receivable turnover formula shown above, filling out the details as necessary.
For example, if your company had a net credit sales amounting to $1.5M and an average AR balance of $150,000 during the prior year. Using the receivables turnover formula: $1,500,000/$150,000, we get an accounts receivable turnover ratio of 10. This ratio indicates that your company’s AR turned over at a rate of 10 during the prior year.
What Accounts Receivable Turnover Ratio Tells You
This ratio lets you know your collection team’s efficiency in staying on top of collectibles. Since it shows the rate at which customers pay off their outstanding invoices, it can be an essential KPI for your overall cash management.
A high AR turnover ratio is viewed as optimal, particularly if a company constantly meets its sales targets and doesn’t have restrictive AR policies that negatively impact revenue. Business scope and industry can also impact receivable turnover. It’s always best to compare yours to businesses in the same industry to gauge the effectiveness of your AR management.
How to Calculate Accounts Receivable Collection Period
Now that you’ve gathered all of the necessary variables, you can finally calculate your AR collection period. To recap, here’s the AR collection period formula:
Average Collection Period = (Days in Period x Average Accounts Receivables) : Average Credit Sales Per Day
The “days” refers to the number of days in your chosen period. The “receivables turnover,” which we have discussed earlier, is the rate at which you collect AR. You get this ratio by dividing your net credit sales by your average AR balance over your chosen period.
Upon calculation, we arrive at the “period,” which is simply the Accounts Receivable Collection period, or the amount of time your customers repay you on average.
Using the example above, with a net credit sale of $1.5M and an average AR balance of $150,000, you’ll have an accounts receivable turnover ratio of 10. Since this receivables turnover was for a prior year, you’ll have to substitute 365 for “days.”
Period = 365/10
If you’re computing for six months, substitute the day figure with 180, or 90 if you’re calculating for three—simple enough.
Period = 36.5 days
In this case, it takes an average of 36.5 days for invoices to be fulfilled, from date of sale to date of actual cash payment.
What’s the Difference Between AR Receivable Collection Period and DSO?
DSO, or days sales outstanding and accounts receivable collection period, analyzes the same metric, which is how long it takes, on average, for customers to settle their unpaid invoices. However, the two use different formulas to arrive at their consecutive results.
DSO is calculated by dividing the total number of AR during a period by net credit sales during that same period. You then need to multiply the result by the number of days you’re trying to measure.
DSO = (Average Accounts Receivable : Revenue) x 365 Days
Let’s say your company has an accounts receivable balance of $150,000 while making a $1.5M net credit sales in the prior fiscal year. Using the DSO formula, we can calculate the days sales outstanding in the number of days.
DSO = ($150,000 / $1,500,000) * 365
DSO = 36.5 days
In this example, your company takes 36.5 days to collect cash from customers. Quite similar to our example above on AR collection period.
Utilizing Your AR Collection Period
Companies compare their AR collection period on their own policies regarding customer payment terms. For example, having a collection period of 36.5 days on top of a 45-day company payment policy shows you’re efficient at collecting what customers owe.
On the other hand, a 36.5-day average collection period under a 15-day payment policy means that you might not be collecting as efficiently as you should.
You can also use this metric in comparison to industry standards. Find out the specific period that’s acceptable for your particular industry. Also, comparing your AR collection period to other firms in your industry, particularly those who you know perform well, can help you gauge how well your own cash management is doing.
If you want, you can plot consecutive AR collection periods to form trend lines, on a month-over-month basis. Trends allow you to spot problems by watching for spikes and drops in your AR collection period trend.
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