How Long Does a Collection Usually Take?

Regarding accounts receivable (AR), the average collection period is the time it takes a company to get payments that are due from its customers. Companies employ the average collection period to ensure they have enough cash on hand to satisfy their financial responsibilities. For businesses whose cash flows primarily depend on receivables, the average collection period is a crucial measure that shows how well an organization manages its accounts receivable.

The Function of Average Collection Periods

Money that organizations owe a firm after purchasing products and services is referred to as accounts receivable in the business world. These are often credit-based sales that businesses make to their clients. AR is a liquidity indicator reported as current assets on company balance sheets. As a result, companies show that they can settle their immediate bills without depending on other funding sources.

The average number of days from the date of a credit sale to the date the buyer remits payment is represented by the accounting indicator known as the average collection period. An organization’s success with AR management procedures may be determined by its average collection period. To run efficiently, businesses need to be able to control their average collection period.

Generally, a shorter average collecting time is preferable to a longer one. A low average collection period indicates an organization that collects money more quickly. This might nevertheless indicate that the conditions of the company’s borrowing are excessively stringent. Consumers may look for suppliers or service providers with more accommodating payment terms if they don’t think their creditors’ conditions are enjoyable.

The Average Collection Period Formula

The average collection period is determined by taking the net credit sales for a given period and dividing the average accounts receivable amount by the firm’s net credit sales. The quotient is then multiplied by 365 days.

Three hundred sixty-five. The average collection period is days * (average accounts receivable and net credit sales).

An alternative and more often used way to calculate the average collection period is to divide the total number of days in a given period by the receivables turnover ratio. The day sales receivable ratio is another name for the calculation used below.

Receivables Turnover Ratio / 365 Days is the average collection period.

The method below is a more concise way of stating the formula: the average accounts receivable amount divided by net credit sales to determine the average receivables turnover.
Average Due Dates

The calculations above determine the average accounts receivable by averaging the starting and ending amounts for a specific period. By taking into consideration daily ending balances, more advanced accounting reporting systems could automatically calculate an organization’s average accounts receivable for a specified period.

Consider the seasonality of the accounts receivable balances while examining the average collection period. For instance, comparing a peak month to a sluggish month might lead to an erratic average balance of accounts receivable, distorting the computed amount.

Sales with Net Credit

The average collection period also depends on net credit sales for a while. Cash sales should not be included in this category since they are not made on credit and do not have a collection period.

Net credit sales are restricted solely to credit sales and do not include residual transactions, which can hurt sales volumes. This covers customer discounts, product recalls, returns, and products that are reissued under warranty.

Ensure that the average receivables and net credit sales are calculated within the same period when determining the average collection period. For instance, the starting and ending receivable amounts taken from the balance sheet must coincide when examining a company’s full-year income statement.

Average Collection Period’s Significance

Although the average collection period is reduced to a single figure, it serves many purposes and conveys a wide range of crucial information.

• It indicates the effectiveness of debt collection. This is significant because a credit sale is not considered final unless the firm is paid. A business cannot fully benefit from a deal until money has been collected.
• It indicates the severity of the credit terms. This is crucial because tight credit conditions might turn away customers, while too-loose credit conditions can attract those who want to take advantage of flexible payment schedules.
• It provides information about rivals’ performances. This is significant since publicly traded corporations can access all the data required to determine the average collecting period. This provides a more in-depth understanding of what other businesses are doing and how an organization’s operations stack up.
• It warns about poor allowances in advance. This is significant since more clients delay their payments as the average collection period rises. This measure may alert management to the need to check its delinquent accounts that may not be collected to ensure that customers are being kept informed and cared for.
• It describes the immediate financial health of an organization. This is crucial because, without cash collections, a business would become bankrupt and be unable to fulfill its immediate debts.

How to Utilize the Mean Time of Collection

The average collection period is not a very useful statistic on its own. Alternatively, you may use it as a comparison tool to extract more value from its worth.

The most excellent strategy for a firm to gain is to figure out its average collecting period regularly and use it to look for patterns in its operations over time. A company’s rivals can be compared separately or collectively using the average collection period. The average collection period may be used as a benchmark to compare the performance of two organizations because similar businesses should provide comparable financial measures.

Businesses might also contrast the typical collection duration with the credit conditions given to clients. For instance, if bills have a net 30-day due date, an average collection duration of 25 days isn’t as alarming. However, a continuous review of the outstanding collection period immediately impacts the organization’s cash flows.

It is not always necessary to state the average collecting duration according to external regulations. Additionally, it is typically excluded from financial covenants. The average collection duration helps provide management with operational information.

An Illustration of the Typical Collection Period

As previously mentioned, the average balance of AR is divided by the total amount of net credit sales for the period, and the quotient is then multiplied by the number of days in the period to get the average collection period.

Assume a business has an average annual receivables amount of $10,000. During this time, the business reported $100,000 in net sales overall. To determine the period, we would utilize the average collection period formula shown below:

($10,000 ÷ $100,000) × 365 = Mean Time to Collect

As a result, the typical collecting time would be 36.5 days. This number is not awful because most businesses collect it within 30 days. The business may pay its debts by collecting its receivables in a fair amount of time, allowing it to do so.

This firm would need to implement a more aggressive collection program to reduce its average collection duration, which might exceed 60 days. If not, it could discover that it cannot meet its debt obligations.

Turnover of Accounts Receivable (AR)

The account turnover ratio, determined by dividing total net sales by the average AR balance, is strongly associated with the average collection period.

Using the earlier example, the AR turnover is 10 ($100,000 ÷ $10,000). By dividing the total number of days in the period by the AR turnover, one can also get the average collection period. The average collecting duration in this case is 36.5 days, just like in the previous one.

Average Collection Period = 365 ÷ 10

Industries’ Collections

Not every firm handles cash and credit in the same manner. Every firm needs cash, but some depend more on their cash flow than others.

For instance, the banking industry is highly dependent on receivables due to the loans and mortgages that it provides to customers. Banks need to process receivables quickly since their revenue comes from these items. Financial harm would result from a decline in income if they had inadequate rules and processes in place for collection.

Real estate and construction enterprises depend on consistent financial flows to pay for labor, services, and materials. While sales and construction take time and may experience delays, individuals working in these sectors must bill at proper intervals. These industries don’t always make cash as quickly as banks.

Why Does the Average Duration of Collection Matter?

The efficacy of an organization’s accounts receivable management strategies is demonstrated by the average collection period. This is crucial for businesses whose financial flows significantly depend on their receivables. Businesses must control their average collection period if they wish to have enough cash to meet their financial obligations.

How Is the Mean Duration of Collection Determined?

Divide the average accounts receivable amount by the total net credit sales for the period to find the average collection timeframe. The quotient should then be multiplied by the total number of days in that particular time frame.

Therefore, the average collection period for a firm with $100,000 in total net sales and an average accounts receivable amount of $10,000 each year would be ($10,000 ÷ $100,000) × 365), or 36.5 days.

Why Is It Better to Have a Lower Average Collection Period?

Businesses prefer a smaller average collection period over a longer one since it shows the company can effectively recover its receivables.

This might mean the company’s credit terms are very stringent, which is a disadvantage. If terms are too strict, customers may defect to competitors with more accommodating payment conditions.

How Can an Organization Raise the Mean Time of Collection?

There are several ways a business might raise its average collection period. It can impose more stringent credit conditions, such as a maximum number of days an invoice can remain unpaid. This may also entail reducing the number of customers to whom it extends credit to boost in-person sales. Additionally, it can provide price breaks for early payments (e.g., a 2% reduction for payments made within ten days).

The average collection period is the average time it takes to collect a credit sale. The customer is receiving a very short-term “loan” from the firm during this time; the sooner the client repays the loan, the sooner it will have the funds to expand its business or settle its bills. A shorter average collection period is generally preferable, but loan conditions that are excessively stringent risk alienating potential consumers.

Conclusion

• The average collection period is when a company must collect its accounts receivable.
• To ensure they have enough cash to pay their financial responsibilities, businesses figure out the typical collection period.
• One can calculate the average collection period by dividing the average AR balance by the total amount of net credit sales and multiplying the result by the number of days in the period.
• This time frame demonstrates how well an organization manages its AR.
• A low average collection period indicates a company that collects money more quickly.