Average Collection Period: Formula, Interpretation & Tips
Alex Louisy
Dec 24, 2024
Efficient cash flow is essential for any business, and understanding how quickly you collect payments from customers is key.
Average Collection Period is a vital metric that gives insight into your company’s ability to convert credit sales into cash, impacting everything from liquidity to credit policy.
A well-managed collection period can lead to stronger financial health, while a lengthy one may indicate areas for improvement. Keep reading to find out:
Curious about other AR metrics could help boost your cash flow? Click below to download our free AR metrics spreadsheet and learn how to calculate the metrics that matter most to your business.
What is Average Collection Period?
The Average Collection Period is a financial metric that measures how long, on average, it takes a company to collect payments from customers. This period is important for understanding the company’s cash flow cycle and evaluating its ability to manage accounts receivable effectively.
A shorter collection period generally indicates that the company collects payments efficiently, contributing to a steady cash flow. A longer period may highlight inefficiencies or lenient credit terms, and could signal that the company should tighten its credit terms or improve its collections processes to ensure better liquidity.
Average Collection Period Formula
To calculate the Average Collection Period, you divide the average accounts receivable by net credit sales and then multiply by 365. The formula looks like this:
or you could simply divide 365 by your accounts receivable turnover ratio, and the simplified formula looks like this:
For example, if your net credit sales for the year is $100,000, and your average accounts receivable for the year is $10,000 (start of year: $8,000 and end of year: $12,000), then your AR turnover ratio is 100,000/10,000 or 10, which makes your average collection period 36.5 days (365/10). This means, it takes on average 36.5 days for you to receive cash for a credit sale.
Average Collection Period & Accounts Receivable Turnover
The Average Collection Period translates the accounts receivable turnover ratio into the average number of days it takes to collect payments, offering a clear view of collection efficiency.
While the turnover ratio shows how frequently receivables are collected within a specific period (10 times in the example above), the average collection period expresses this as a time frame (36.5 days in the example above), making it a more tangible measure of how long it takes to receive payments. This provides a practical perspective on the effectiveness of a company’s collection process.
Importance of Average Collection Period
The average collection period is important for various aspects of your business, and here are a few of them:
Cash flow management: The Average Collection Period helps companies assess how quickly they can convert credit sales into cash, impacting their liquidity and ability to meet short-term obligations. A shorter collection period supports healthier cash flow and minimizes reliance on external financing.
Credit policy assessment: By analyzing this period, businesses can evaluate the effectiveness of their credit terms and policies. If the period is too long, it may suggest overly lenient credit terms, while a shorter period can reflect stricter credit policies or efficient collections.
Insights into customer payment behavior: Monitoring the Average Collection Period reveals trends in customer payment habits, allowing companies to identify potential issues early, such as consistent late payments from certain clients, and to adjust customer financial relationship strategies accordingly.
Benchmarking against industry standards: This metric enables companies to compare their collection efficiency against industry averages, helping to highlight competitive strengths or areas needing improvement. Falling behind the industry benchmark can signal potential collection inefficiencies or policy gaps.
Forecasting and budgeting: A predictable Average Collection Period aids in cash flow forecasting and budgeting, providing a reliable estimate of when funds will be available for business expenses, investments, or growth opportunities. This helps in planning financial resources effectively.
What is a Good Average Collection Period?
There's no one-size-fits-all answer for what makes a "good" Average Collection Period. Ideally, a shorter collection period is generally preferred, as it indicates that the company collects receivables quickly and has efficient credit and collections practices. This typically suggests a well-managed cash flow and a more financially stable operation, as funds are being reinvested into the business sooner.
What makes a good average collection period varies widely by industry, as well. To get a benchmark, one can look at the median DSO (a metric very similar to the average collection period) for their industry. In our State of B2B Payments in 2024 report, as seen below:
We found out that traditional industries like Office & Facilities Management and Consulting tend to have significantly higher DSOs or collection periods, often operating under 90-day payment terms. In contrast, Clothing, Accessories, and Home Goods businesses report the lowest median DSOs among all sectors tracked by Upflow.
This difference likely stems from their dependence on physical inventory, creating a need for faster payments after each transaction. These companies can also enforce timely payments more effectively by controlling credit exposure, as customers cannot receive additional inventory until previous invoices are paid. This is in stark contrast to sectors like Office & Facilities Management, where the inability to "remove" clients from services due to non-payment makes enforcing prompt collections more challenging.
Ultimately, what constitutes a “good” Average Collection Period depends on the industry, and businesses should set targets based on their sector’s benchmarks to ensure effective and realistic cash flow management.
How to Improve Your Average Collection Period?
Here are five strategies to improve your Average Collection Period:
Implement a consistent invoicing system: Set clear, predictable billing schedules to ensure customers know when and how they’ll be invoiced. A consistent process helps clients plan their cash flow and reduces the likelihood of payment delays.
Streamline invoices for clarity: Ensure that invoices are easy to read and understand, detailing each charge clearly. Well-organized invoices prevent confusion and make it easier for customers to review and approve payments quickly.
Automate payment reminders: Avoid overwhelming clients with reminders by setting up automated, account-level notifications that show the full outstanding balance. This makes it simpler for customers to see their obligations at a glance and settle all due payments at once. You can easily do this by using a financial CRM like upflow.
Offer flexible payment options: Enable multiple payment methods, including online options, to give customers convenient ways to pay as soon as they receive an invoice. Providing tailored payment terms can also encourage timely payments and reduce your collection period.
Incentivize early payments: Offer discounts for early payments to motivate clients to settle invoices sooner than the due date. These discounts can improve your cash flow and offset any delays from slower-paying customers.
Using these strategies consistently can help you shorten your average collection period, leading to improved cash flow and stronger financial health.
Key Takeaways:
The Average Collection Period measures the average time it takes for a company to collect payments from its customers, serving as a critical indicator of cash flow efficiency and receivables management.
A "good" Average Collection Period varies significantly by industry; companies should benchmark against sector-specific averages to set realistic collection targets.
A shorter Average Collection Period enhances liquidity, enabling businesses to meet short-term obligations and reinvest funds more quickly, which contributes to overall financial stability.
Businesses can enhance their Average Collection Period by implementing consistent invoicing practices, automating payment reminders, offering flexible payment options, and incentivizing early payments.
Continuous assessment of the Average Collection Period is essential for identifying trends in customer payment behavior and adjusting credit policies to maintain optimal cash flow management.
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