In a perfect world, companies receive all payments upfront or see immediate invoice payments. Instead, companies often chase invoice payments and struggle with late payments. Some businesses also have different payment arrangements with each client. The average collection period for accounts receivable consolidates this information.
What Is an Average Receivables Collection Period?
An average receivables collection period refers to the typical time it takes for companies to receive invoice payments. More specifically, it describes the time that elapses between the sales date and the date the customer paid for the goods or services rendered.
How Do Businesses Calculate the Average Collection Period Ratio?
Example: “Bradley Trucking Co.” averages $50,000 in accounts receivables. The total credit sales for that year was $500,000. To determine how many times per year the company got paid, the average collection period formula begins with $500,000 divided by $50,000, which is ten.
There are 365 days in a year, so:
365 ÷ 10 = 36.5
What Is an Alternative Average Collection Period Formula?
The alternative average receivables collection period calculation arrives at exactly the same DSO, despite changing the steps.
Example: “Affordable Wholesale LLC” averages $50,000 in accounts receivables. It also totals $500,000 in credit sales that year. This calculation first requires $500,000 divided by the 365 days of the year, which is $1,369.86. Next, divide the average receivables ($50,000) by the figure. This also amounts to 36.5 days.
Why Do Businesses Need To Know the Average Days to Collect Receivables?
Cashflow management is one of the most crucial tasks companies manage to remain profitable and solvent. Even when companies can pay their bills, if they don’t have additional cash on hand, it hinders expansion. Knowing when to expect invoice payments can make it easier for the company to plan.
Identifying the average time for invoices to be converted to cash can help companies mitigate associated risks. Using the previous examples, both companies might decide they need at least 5 weeks’ worth of cash in the bank to ensure they can meet their regular financial obligations.
Finally, the average turnaround time for invoice payments can impact how a business accesses funding and how much money it qualifies for. It might be especially important when factoring accounts receivables and when proving good cashflow management to investors.
What Creates Fluctuations in the Average Collection for Accounts Receivable?
There is general consensus that shorter average collection ratios are more beneficial for businesses. However, pinpointing what creates fluctuations in the average payment time can be difficult. Knowing the reasons for fluctuations can help the company maintain shorter times and correct longer averages.
1. Credit Policy Changes
When companies reduce how strict their credit policies are, it opens the door for some clients to abuse that freedom. While this can lead to more short-term sales, it means longer lead times on payments and potentially higher default rates. In contrast, when companies tighten their credit policies, sales might dip but average payment times are also reduced.
2. Collection Policy Changes
When there is a collections officer and an established collection policy, clients tend to pay more quickly. This may be due to pressure from the collections officer or the desire to avoid the potential for pressure. In contrast, when companies get rid of collections officers or lighten their collections policies, default or late payments become more likely.
3. Economy Fluctuations
How well businesses do will affect the economy and vice versa. When economies go into decline, companies might have a far more difficult time meeting financial obligations because customers tend to reduce spending. Similarly, when economies experience booms, companies also tend to grow and are in a better position to pay their bills.
Every industry and business will have its own appropriate average collection period. It might take a few years of operation to determine what is normal for the business and to create strategies to maintain or improve that average. Gaviti can help you speed up this process by generating key data and revolutionizing the way your accounts receivable department works.
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