1. Definition
Average collection period is computed by dividing the number of working days for a given period (usually an accounting year) by receivables turnover ratio. It is expressed in days and is an indication of the quality of receivables.
Average collection period = 360 / Accounts Receivable Turnover
2. Example A
| Total sales | 176000 |
|---|---|
| Cash sales | 77000 |
| Accounts receivables | 8000 |
| Note receivables | 3000 |
Account receivable turnover = Net sales and other revenues / Accounts receivables
= Credit sales / Account receivables
= (Total sales - Cash sales) / (Account receivables + Note receivables)
= (176000 - 77000) / (8000 + 3000)
= 99000/11000
=9
The account receivable turnover shows that we need to collect 9 times in order to get back all money.
Suppose the current credit receivables can be received within one year (360 days). Then the average collection period can be calculated as follows,
Average collection period = 360 / Account receivable turnover
= 360 / 9
40
Like account receivables turnover, average collection period is of significant importance when used in conjunction with liquidity ratios. A short collection period means prompt collection and better management of receivables. A long collection period may negatively affect the short-term debt paying ability of the business in the eyes of analysts.
Compare a company’s credit terms and average collection period. Whether a collection period is good or bad, depends on the credit terms allowed by the company. For example, if the average collection period of a company is 50 days and the company allows credit terms of 40 days then the average collection period is worrisome. On the other hand, if the company’s credit terms are 60 days then the average collection period of 50 days would be considered very good.