Most businesses rely on cash flow they have yet to receive from customers who have purchased their goods and services. Net income is often delayed due to purchases of credit terms, late payments, and other factors.
The accounts receivable collection period is a metric used to measure the average time customers pay off any outstanding invoices. This helps business owners better understand their cash flow and identify trends or issues with their collections process.
Given its intimate connection to cash flow, critical to any business's success, accurately calculating your accounts receivable collection period is essential. To do this properly, you must understand the formula used to calculate it and the factors that can affect its accuracy.
Read on to learn the formula for calculating your accounts receivable collection period and how to use it effectively. You'll also learn more about why this metric is so important, who should be involved in calculating it, and what actions you can take if your collections take too long.
What is the accounts receivable collection period?
Let's start with a thorough definition.
The accounts receivable collection period is the average collection period for a business to collect its outstanding invoices. A low collection period indicates that customers pay their invoices quickly, while a more extended collection period shows customers may take too long to deliver.
It's an essential metric for companies that offer credit terms, as it measures their effectiveness at collecting the payments owed by customers.
Accurately assessing their accounts receivable collection period helps businesses plan their cash flow and budget accordingly.
Why is the accounts receivable collection period so important?
For several reasons, keeping an accurate measurement of the accounts receivable collection period is vital for businesses. The accounts receivable collection period:
Gives a clear indication of how well the credit terms are performing
If the accounts receivable collection period is more extended than expected, this could indicate that customers don't pay on time. It's a good idea to review your balance sheet and credit terms to improve collection efforts.
Key performance metrics such as accounts receivable turnover ratio can measure your business's ability to collect payments in a timely manner, and is a reflection of how effective your credit terms are.
Helps to identify and address any payment problems quickly
Efficient management can be achieved by regularly monitoring the accounts receivable collection period. Businesses can spot any payment issues quickly and take action to improve the situation, improving their total net sales and ability to manage accounts receivable balances.
Allows for better cash flow forecasting
Knowing the accounts receivable collection period helps businesses make more accurate projections of when money will be received.
It can optimise your average collection period formula and provide a new performance metric to help you gauge business performance. Better cash flow means that you have enough cash to continue running your company.
Highlights any issues with your accounts receivable collection process
The accounts receivable collection period may be affected by several issues, such as changes in customer behaviour or problems with invoicing.
Identifying these issues and resolving them can lower the number of days in your company's average collection period, and will display how effectively your accounts receivable department is performing.
Makes it easier to manage customer accounts more effectively
Understanding the accounts receivable collection period makes it easier to take appropriate action to ensure that customers are paying on time.
If you don't receive payments in a timely manner, then it can be tough to calculate net credit sales.
Prevents cash flow issues by ensuring bills are being paid on time
By understanding the accounts receivable collection period, businesses can identify any issues that may lead to cash flow problems and take steps to address them.
What does a low average collection period indicate?
Companies typically favour a lower average collection period because it means there's a shorter time between converting your average balance from accounts receivable to cash. It means a company is able to receive payment from customers much sooner.
However, a lower average collection period can also indicate that a company's credit terms are too strict. A low average collection period figure doesn't always indicate increased total net sales, especially if credit sale numbers are low.
Accounts receivables will vary greatly from one company to another, but it's important to compare total credit sales with average collection periods to get a better understanding of a company's cash flow.
How do you calculate the account receivable collection period?
The formula for calculating your accounts receivable collection period is relatively simple: Take the total amount of accounts receivable at the beginning of a certain period, and divide it by the average net collection for that same period. This will give you your average collection period in days!
If you put that as a formula for a single year, it looks like this:
(average accounts receivable balance ÷ net credit sales ) x 365 = average collection period.
You can also essentially reverse the formula to get the same result:
365 ÷ (net credit sales ÷ average accounts receivable balance) = average collection period.
Average accounts receivable balance
As you might have noticed from the formula above, in order to work out your average collection period, you need to know your average accounts receivable balance.
Your average accounts receivable balance is the average amount of money that your customers owe you.
To work this out, you must total your accounts receivable at the start of each period and again at the end. Then, calculate the average by adding both amounts and dividing by two.
Turned into a formula, it looks like this:
(total accounts receivable balance at the beginning of the period + total accounts receivable balance at the end of the period) ÷ 2 = average accounts receivable balance.
Net credit sales
You'll also need to understand your net credit sales. This is the amount of money customers owe you for goods and services minus any returns and discounts you offer.
To calculate this figure, total all sales made with credit over a period of time. Then, subtract returns and discounts from that number to get your net credit sale balance.
Rendered as a formula, it looks like this:
Total net credit sales – (returns + discounts)
Make sure the same period is being used for both net credit sales and average receivables by pulling the numbers from the same balance sheets.
Average collection period calculation
The average collection period is calculated by dividing total average accounts receivable balance by the net credit sales for a given period. You then multiply the result by 365.
Average collection period = 365 × (average accounts receivable ÷ net credit sales)
Alternatively, you can calculate the average collection period by dividing the number of days of a given period by the receivable turnover ratio.
Average collection period = 365 ÷ receivable turnover ratio
This formula is often referred to as the days sales receivable ratio.
How to improve your accounts receivable collection period
If you find that your accounts receivable collection period is too long, there are several things you can do to improve it. Here are a few ideas:
Invoice promptly and accurately
Send invoices once goods or services have been provided. Ensure that their information is up-to-date and accurate, with all the payment data that the customer needs to make a prompt payment.
Offer discounts or other rewards to customers who pay on time. This can help encourage prompt payments and build positive customer relationships.
Set up automated reminders
Make sure you don't miss payment deadlines by sending follow-up emails or calls. Automated email and SMS reminders can be sent to customers to remind them of upcoming payment due dates without contacting them manually.
Accept different forms of payments
Offer customers a range of payment options such as credit cards, direct deposits, and online payments. This will make it easier for them to pay on time.
Be friendly but firm
Polite persistence is critical. Remain professional and understanding but also firm in reminding customers of the importance of prompt payments. Remind them of your credit policies, collection periods and financial obligations to ensure the client pays on time.
Keep accurate records
Log all payments and communication with customers so you can easily track and follow up if necessary.
Review payment terms regularly
Review your payment terms from time to time to ensure they are still appropriate for your business needs. Most companies will review their payment terms once or twice a year to achieve a good average collection period.
These options are easy to implement and can help you manage customer payments more effectively, reducing your accounts receivable collection period.
Accounts receivable collection period example
Now that we've given you a better idea of the accounts receivable collection period, why it's essential, and how to calculate it, let's look at an example.
Say you sell gardening supplies and had a total of $30,000 in sales during the month of May. Once you subtract returns and discounts, your total net credit sales balance comes to $29,000.
During this same period, your customers paid $21,000, and it took an average number of 30 days to collect payment. Your accounts receivable collection period is 30 days.
How Chaser can help
Chaser's automated credit control platform is designed to reduce your collection period, improve cash flow, increase net sales and save you time.
By allowing you to automatically chase your customers for payments, you can stay on top of your invoices and ensure they are paid on time. It makes it easy to receive payment in a speedy time frame, and lowers the number of days to collect payments.
The platform allows you to create personalised payment reminders, set up automatic chasing schedules and even send friendly payment requests via email and SMS to your customers. You can also keep track of payments with visual reports, allowing you to manage outstanding invoices proactively.