The average collection period is the timea company’s receivables can be converted to cash. It refers to how quickly the customers who bought goods on credit can pay back the supplier. The earlier the supplier gets the funds, the better it is for business because this fund is a huge source of liquidity.
The Average Collection Period formula calls for calculating the average accounts receivable balance and net credit sales for a specified timeframe. The average accounts receivable is determined by taking the sum of the beginning and ending balances, then dividing that amount by two. Net credit sales are calculated as total sales made on credit minus any discounts or returns during the same period. The Days Sales Outstanding (DSO) is a critical metric in calculating the average collection period. It measures the average number of days a company takes to collect payment after a sale has been made. Through DSO, a company can gauge the effectiveness of its credit policies and collection efforts.
We will take a practical example to illustrate the average collection period for receivables. HighRadius’ AI-powered collections software helps prioritize worklists for the top 20% of customers and automates collections for 80% of long-tail customers. This results in a 20% reduction in past-due accounts and a 30% increase in collector productivity. HighRadius offers a comprehensive, cloud-based solution to automate and streamline the Order to Cash (O2C) process for businesses. By benchmarking against the industry standard, a company can gauge easily whether the number is acceptable or if there is potential for improvement.
Comparing Against Industry Norms
The average collection period indicates the effectiveness of a firm’s accounts receivable management practices. It is very important for companies that heavily rely on their receivables when it comes to their cash flows. Businesses must manage their average collection period if they want to have enough cash on hand to fulfill their financial obligations. The average receivables turnover is simply the average accounts receivable balance divided by net credit sales; the formula below is simply a more concise way of writing the formula. If a business offers a 30-day credit term, an average collection period near or below 30 days is often seen as efficient. This timely turn-around keeps cash flows steady and can indicate a strong collection process.
Accounts Receivable (AR) Turnover
Encouraging clients to settle their accounts earlier than the due date can significantly shorten your Average Collection Period. Monitor ReceivablesKeep a close eye on outstanding receivables and follow up regularly with clients who have overdue balances. A proactive approach to collecting payments reduces the need for more aggressive measures, such as late fees or collections agencies. However, an overly aggressive collections process might lead to strained customer relationships or even the loss of business opportunities.
Free Accounts Receivable guide
This section will cover three primary external factors—economic conditions, competition, and customer behavior—and how they influence a company’s average collection period. Comparing your organization’s industry benchmarks helps determine whether its average collection period is within a reasonable range. A company with a significantly higher or lower than average collection period should investigate the reasons behind it and take necessary measures to improve efficiency in managing their accounts receivable. It’s important to note that some industries may have unique factors influencing their average collection periods. For example, the healthcare industry faces more debtor collection period formula complex payment processes due to insurance claims, discounted rates, or government reimbursements.
Why Is the Average Collection Period Important?
- Selecting the correct formula for your business vitally hinges on your particular accounting practices regarding recording of credit sales and receivables.
- If this company’s average collection period was longer—say, more than 60 days— then it would need to adopt a more aggressive collection policy to shorten that time frame.
- We found out that traditional industries like Office & Facilities Management and Consulting tend to have significantly higher DSOs or collection periods, often operating under 90-day payment terms.
- You need to calculate the average accounts receivable and find out the accounts receivables turnover ratio.
- Monitor ReceivablesKeep a close eye on outstanding receivables and follow up regularly with clients who have overdue balances.
Managing payment terms effectively directly influences a business’s financial health and, consequently, its average collection period. By adjusting payment terms to encourage customers to pay promptly, a business can streamline its finances and keep its cash flowing. Implementing stringent credit policies, where credit is extended only to reliable customers, is another effective strategy. It curbs the problem of late payments, which in turn minimizes the risk of impacting the average collection period adversely. To reduce the average collection period, proactive, well-planned strategies must be adopted.
- Understanding these factors can help businesses optimize their collections processes and minimize Days Sales Outstanding (DSO).
- By examining these metrics, businesses can gauge their efficiency in managing cash flows and optimizing their working capital, ultimately providing a competitive edge.
- A shorter average collection period can significantly streamline operations and enhance a business’s financial health.
- In that case, the formula for the average collection period should be adjusted as needed.
- Thus, working towards shortening the average collection period places businesses in a stronger financial position, making way for sustainable growth and profitability.
If your period is significantly lower than the industry average, your credit and collection policies might be more aggressive than necessary, potentially scaring away customers who require more flexibility. However, if it’s higher, there’s a chance that your policies are lax, exposing you to higher credit risk and slower cash inflow. Automate Invoice ProcessesAutomating invoice processing can significantly reduce the time it takes for customers to receive and pay their invoices. Electronic invoicing, automated payment reminders, and real-time tracking can streamline collections and improve customer service. By adopting these practices, businesses can minimize days sales outstanding (DSO) and improve their overall financial health. Similarly, a steady cash flow is crucial in construction companies and real estate agencies, so they can pay their labor and salespeople working on hourly and daily wages in a timely manner.
Significance of Monitoring Your Average Collection Period
In essence, it represents the average number of days between recording a credit sale and receiving payment from clients. In conclusion, external factors such as economic conditions, competition, and customer behavior significantly influence an organization’s average collection period. By carefully considering the impact of external factors on their business, companies can make informed decisions that maximize their cash flow while minimizing their days sales outstanding. Understanding the significance of an efficient collections process lies in its ability to ensure a company’s liquidity and short-term financial health. A shorter average collection period means a faster conversion of accounts receivables into cash, allowing for improved credit management and better cash flow control.
At the beginning of the year, your accounts receivable were at $5,000, which increased to $10,000 by year-end. As many professional service businesses are aware, economic trends play a role in your collection period. Seasonal fluctuations impact payment behaviors, which in turn affect your average collection period.
This can mean you’re getting cash back into your business swiftly, which is critical for paying expenses, purchasing inventory, and keeping your operations running smoothly. You can calculate the average accounts receivable balance by taking the average of the beginning and ending balances over a given period. To compute net credit sales, exclude cash transactions and any residual transactions that reduce the sales figure, such as discounts, returns, or re-issued items under warranty. Grasping the fundamentals of the average collection period is a requisite for any business owner.
In today’s business landscape, it’s common for most organizations to offer credit to their customers. If your business follows suit by extending credit to customers, it becomes crucial to efficiently manage payment collections. Consider automating your accounts receivable (AR) processes with tools like Billtrust, which streamline and accelerate billing, minimizing human error and freeing up time to focus on core business aspects. Proactive collections approaches also pay dividends; establish clear communication channels with customers and follow up promptly on overdue accounts. By adopting these best practices, your organization can minimize the days sales outstanding (DSO) and strengthen its financial position in the long run. Remember, timely collections not only provide immediate benefits but also contribute to a positive image of your brand as a reliable and customer-focused business partner.
Every company monitors this period and tries to keep it as short as possible so that the receivables do not remain blocked for a long time. Real estate and construction companies also rely on steady cash flows to pay for labor, services, and supplies. When analyzing average collection period, be mindful of the seasonality of the accounts receivable balances. For example, analyzing a peak month to a slow month by result in a very inconsistent average accounts receivable balance that may skew the calculated amount.