How well does the company do on collecting cash from its customers?
For example, the company may sell a product to one of the customers today. The sale could be made on credit and an invoice is issued for payment. If the payment from the customer is received in 45 days from the date of the invoice (or sale), the collection period in this example is 45 days.
Average Collection Period is also called Days Sales Outstanding (DSO).
Calculating Average Collection Period
Average collection period can be calculated as a ratio of Average Accounts Receivable and the Net Credit Sales and then multiplied by the days in the period that we are evaluating.
Average Collection Period = (Days x Average AR/Net Credit Sales)
Average AR can be approximated as an average of the beginning and ending Accounts Receivable figures for the period.
For example, if a company has net credit sales of $1,000,000 for the period of 1 year (Days = 360 for simplicity), and the beginning AR was $90,000 and ending AR was $110,000, then
Average AR = ($90,000 + $110,000)/2 = $100,000
Average Collection Period = 360 x $100,000/$1,000,000 = 36 days.
This means the company on average collects payments from its customer in 36 days after the sales.
Obviously, a quicker collection is better than a longer collection period. This minimizes the accounts from going bad and cash is turned over quickly. However, in practice, each industry evolves with its own standards in terms of supplier payment terms and therefore the average collection periods tend to vary from industry to industry.
This measurement of sales efficacy makes more sense when compared to the competitors in the same industry. It can also be a useful metric to trend over time for a company. This allows us to determine if the sales collection practices in the company as deteriorating or keeping up. In some cases, an increasing average collection period number over time may indicated that the company may be adding customers with worsening credit profile or they may be loosening their credit requirements to increase sales. This may be considered a red flag for the future health of the company.
Average Collection Period is closely related to the Accounts Receivable Turnover. When the Accounts Receivables turn over faster, the company collects cash faster, and therefore the Average Collection Period is smaller.
Average Collection Period = Days/Account Receivable Turnover
If the Account Receivable turnover is 10 in a year (the AR turns over 10 times in an year), than the Average Collection Period = 360/10 = 36 days.