Understanding Average Collection Period
What is Average Collection Period?
In short, average collection period is the amount of time that elapses before an organization or company collects their accounts receivable (A/R) -- the payments that are owed from clients and customers. With proper average collection period monitoring and execution, organizations and businesses can help to ensure that they have enough liquid cash on hand to support short-term financial commitments and plan long term strategies.
Why Average Collection Period is Important
Liquidity and Planning for Future Costs
Average collection period can affect both short and long term financial strategies and decisions. In the short term, businesses must have consistent cash flows coming in or else they might not be able to pay for routine expenses, such as salaries, supplies, etc. A steady flow of liquid cash also allows for better financial planning. The ability to know when you will be paid, and if you can expect those payments to be reliable are essential when determining long term strategies like large purchases or expansions.
Average Collection Period Consistency
Determining the cadence of a collection period can also play a significant factor in financial planning and growth strategies. A shorter collection period allows for a more consistent stream of payments, making it easier to plan for the future and increasing the amount of liquid cash on hand.
However, a shorter collection period can place extra strain on clients and customers, potentially making them less likely to buy your products or services. Finding a middle ground between short and long collection periods will allow a company or organization to reap the benefits of a consistent cash flow, without alienating clients and customers.
How to Calculate Average Collection Period
Calculating average collection period can be done with the standard average collection period formula. In most cases, the average collection period is calculated by numbers of days. By calculating the average balance of accounts receivable for the year and dividing it by total net sales for the year, we can find the average collection period:
Average Collection Period Example
One of the easiest ways to understand average collection period is to see it in action. We have outlined a scenario that illustrates how the average collection period formula works in a real-world example.
A software development company, “ACME Corp',' has an average accounts receivable balance of $60,000. Their net sales were $200,000. ACME Corp now has all of the information that they need to calculate the ratio for average collection period.
Next, they will need to multiply the 365 days of a year by $60,000, resulting in $21,900,000. After that, they will need to divide this number over the $200,000 of net sales. This gives ACME Corp 109.5 days, meaning it takes them, on average, nearly 110 days to collect on their accounts.
ACME Corp’s average collection period figure tells us a few different possibilities. For one, it could indicate that they are lacking in A/R efficiency. Conversely, the result could also indicate that ACME Corp offers a variety of flexible payment options, like leniency on late payments.
As we noted earlier, this double-edged sword shows how companies must create a careful balance between their ability to consistently collect on A/R, but also provide a robust customer experience.
Optimize Your Average Collection Period and A/R
Now that we better understand the importance of average collection period and how to calculate it, we must now learn how to best apply it to A/R strategies and solutions. Invoiced’s automated A/R solutions provide a variety of tools that make planning and executing collections fast and easy. Services like subscription billing, payments plans, and customer portals help to ensure that customers and clients pay regularly and pay on time, making it easier to optimize your average collection period.
Don’t waste precious financial planning and strategizing time. If you would like to learn more about Invoiced’s A/R services, please visit our products page or schedule a free demo with our friendly and knowledgeable team today!