Businesses often rely on cash flow that they haven’t yet received. Net income and sales operate on a delayed schedule, and companies crunch the numbers expecting to settle invoices and get paid sometime in the future.
Once an invoice hits accounts receivable (A/R), it enters what’s called the collection period. Other common names include “days sales in accounts receivable,” “average receivables collection period,” or “days sales outstanding (DSO).”
Your average A/R collection period is an important key performance metric (KPM). It’s smart to know how to calculate your collection period, understand what it means, and how to assess the data so you can improve accounts receivable efficiency.
What Is an Accounts Receivable Collection Period?
Businesses often sell their products or services on credit, expecting to receive payment at a later date. Your collection period tells you how long it takes after a credit sale to receive payment.
You can understand how much cash flow is pending or readily available by monitoring your average collection period. Measuring this performance metric also provides insights into how efficiently your accounts receivable department is operating.
How to Calculate Your A/R Collection Period
Typically, the average accounts receivable collection period is calculated in days to collect. This figure is best calculated by dividing a yearly A/R balance by the net profits for the same period of time.
You can determine net profits by comparing net credit sales during the period (most often a year or 6 months) and your average accounts receivable balance during the period. This is also called your “A/R turnover ratio.”
There are two A/R collection period formulas you can use for calculating your average collection period:
1. The first equation multiplies 365 days by your accounts receivable balance divided by total net sales.
(A/R balance ÷ total net sales) x 365 = average collection period
Example: ($50,000 ÷ $800,000) x 365 = 22.8 days average collection period
2. The second equation divides 365 days by your accounts receivable turnover ratio.
365 ÷ A/R turnover = average collection period
365 ÷ (net credit sales ÷ average A/R balance) = average collection period
Example: 365 ÷ ($800,000 ÷ $50,000) = 22.8 days average collection period
Both equations will produce the same average collection period figure if you have the appropriate data.
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Why Calculating Your Collection Period Is Important
It makes sense that businesses want to reduce the time it takes to collect payment from a credit sale. Prompt, complete payment translates to more cash flow available and fewer clients you must remind to pay every month.
The shorter your collection period—or the lower your DSO/higher your accounts receivable turnover—the better. Shorter, lower, higher: Your goal is for clients to spend less time in accounts receivable and more time paying bills promptly. What’s more, your average collection period contributes directly to achieving company goals and growing your business.
Calculating your collection period is important because:
- Cashflow freedom keeps your business afloat.
- It helps you monitor A/R efficiency.
- It’s easier to compare collection periods with competitors.
- You can better plan for future expenses.
A relatively short average collection period means your accounts receivable collection team is turning around invoices quickly and everything is operating smoothly.
Monitor Average Collection Period to Improve Performance
The secret to accounts receivable management is knowing how to track and measure performance.
It’s not enough to look at a final balance sheet and guess which areas need improvement. You must monitor and evaluate important A/R key performance metrics in order to improve performance and efficiency.
Crucial KPMs like your average collection period can show exactly where you need to make improvements to optimize your accounts receivable and maintain a healthy cash flow.
If you need help establishing KPMs or automating essential accounts receivable collection processes, contact the professionals at Gaviti. We’ve got years of experience eliminating inefficiencies and improving business.