The average collection period is the average number of days that it takes for a business to receive payment after making a sale on credit. The average collection period is important because it's a key metric for measuring the effectiveness of a company's credit and collections policies.
The average collection period is calculated by dividing the average accounts receivable balance by the credit sales for a given period and then multiplying the result by 365, the number of days in a year. For example, if a company has an average accounts receivable balance of $30,000 and net credit sales of $100,000, then its average collection period is $30,000/$300,000 × 365, or 36.5 days.
A high average collection period indicates that a company is having difficulty collecting payments from its customers, which can lead to cash flow problems. A low average collection period indicates that a company is effectively collecting payments from its customers.
There are several ways that businesses can improve their average collection period. One way is to offer discounts to customers who pay their invoices within a certain number of days. Another way is to improve the credit terms offered to customers. For example, a business could offer 2/10 net 30 terms, which means that the customer would receive a 2% discount if they paid their invoice within 10 days, but would otherwise still be required to pay the full amount of their invoice within 30 days.
A business could also improve its collections process by hiring a dedicated collections specialist or by outsourcing its collections to a third-party company.
XYZ company is a manufacturer of automotive parts. The company had an average collection period of 60 days, which was causing cash flow problems. The company decided to improve its collections process by hiring a dedicated collections specialist.
The specialist was able to reduce the average collection period to 30 days within six months. As a result of the improved collections process, XYZ company's cash flow problems were resolved and the company was able to avoid defaulting on its loans.