Average Collection Period Ratio

If you want to learn the meaning of accountability and taking responsibility, try running your own business. There are hundreds of parameters which you need to think about when making any financial decision. A strong accounting department is required to keep an eye on the finances of the company and the cash flow generated. Accounting parameters like the average collection period ratio, make it easy for a business owner to review the financial health of a business.

Definition

To sustain the functioning of any business process, a steady cash inflow needs to be maintained. For that to happen, the delicate balance between income and expenses has to be maintained. Even though goods are produced and sold, there is usually a lag between the sales and actual cash received from the customers.

This lag is reflected in the rate at which the accounts receivables are converted into actual cash inflows. The average time period required to collect payment for goods and services, sold by a business, is called the average collection period ratio. The parameters which decide this ratio are the average accounts receivable generated in a year and the credit sales made by the business in a specific time period.

The ratio varies according to the nature of the business and the types of goods and/or services offered. When a business gets paid for its service immediately and credit sale is high, the collection period ratio will certainly be short. On the other hand, if the total credit sale of a business is low, the collection period will be longer.

The more rapidly accounts receivables are converted into actual cash inflow, better is the liquidity made available for the business. In short, it increases the operational pace of the cash conversion cycle. A high liquidity lets a business pursue developmental projects and effectively sustains the business process. After this average collection period analysis, let us take a look at the formula used for average collection period calculation.

Formula

The formula presented below should make it easier for you to understand what is the average collection period and how is it calculated.

Average Collection Period Ratio = (Accounts Receivable) x (Business Cycle Period) / (Total Credit Sale)

The business cycle period may vary from a year to any length of time less than a year. It all depends on how you want to segment the time period of your business cycle. The accounts receivable may increase or decrease throughout the year as payments are received and new sales are made. In general accounting practice, the average of the account receivable entry on the first and last day of the business cycle is taken into consideration. The total credit sales made by the business during that period is the biggest determining factor, when it comes to calculating the average collection period.

Calculation

An example will make it easy for you to understand the calculation of collection period. Consider that a business had an average accounts receivable of $1,000,000 in a period of 300 days, during which its total credit sales were $3,000,000. What will be the average collection period in days? Substituting the values in the above formula, the average collection period is given by:

Average Collection Period = (1000000 x 300 days) / (3000000) = 100 days

An analysis of the average collection period is necessary to give you an idea about the time taken by the business to generate actual cash flows over the period of a year. This can help you make necessary changes in your business process, to make it smoother and more efficient.