Average Collection Period

The accounts receivable activity ratios indicate the speed with which the company collects its receivables.

The days’ sales in receivables or average collection period is another measure of how efficiently the company is collecting its accounts receivable. The average collection period is the average number of days receivables
are held before being collected.

The average collection period can be calculated in several different ways. Which one is used is simply a matter of personal preference.

Or, a variation on A, because to divide by a fraction, invert the fraction and multiply:

Or

Ratios that use the number of days in a year may be calculated with either 365 days or 360 days per year.

The accounts receivable turnover ratio and days’ sales in receivables, or average collection period, should be compared with industry averages, with previous periods’ amounts for the same company, and with the company’s credit terms. The number of days of sales in receivables should not be higher than the standard credit terms offered by the company. An average collection period that is higher than the standard credit terms offered may indicate poor collection efforts, customer dissatisfaction leading to refusal to pay, customers in financial distress or an extreme delay of payment by one or two large customers.

If the average collection period increases over time while the accounts receivable turnover ratio decreases over time, the analyst should consider the possibility that special conditions exist that have caused the deterioration. For example, the company might be extending liberal credit terms to increase sales, perhaps as a marketing tool to launch a new product or to better utilize excess production capacity.

For both the accounts receivable turnover ratio and the days’ sales in receivables, use the gross accounts receivable balance to calculate the average accounts receivable, if the gross amount is available. Sometimes only the net receivables amount (gross receivables less the allowance for credit losses) is presented on the balance sheet. If only the net amount is available, then use the net amount.

Usually, the average accounts receivable for a period may be calculated as simply the average of the beginning and ending accounts receivable balances. Beginning accounts receivable is the same as the previous period’s ending accounts receivable. However, year-end accounts receivable balances may be distorted if a company chooses a “natural” business year rather than a calendar business year. A company’s natural business year ends at the end of its main selling season when inventories are low (depleted) and accounts receivable from the selling season have been collected. If the company is using a natural business year, averaging beginning and ending balances for the year to calculate the average balance during the year will not yield an average that is representative of average accounts receivable during the entire year, and the resulting accounts receivable activity ratios will be distorted. If the company is using a natural business year and net sales represent a full year’s sales, averaging interim accounts receivable balances to calculate  the year’s average accounts receivable would yield a more accurate average balance of accounts receivable. For example, average the four ending accounts receivable balances for the end of each quarter.

The trend over time in the average collection period and turnover ratio is important. To evaluate the trend, look at the relationship between the allowance for credit losses and gross accounts receivable over time in light of changes in the average collection period and turnover ratio, as follows:

An increase in the above ratio coupled with a deterioration in the average collection period and turnover ratio indicates that the cause of the deterioration is likely a decline in the collectability of the receivables.

If the average collection period and turnover rate have deteriorated but the above ratio has remained the same or decreased, the cause of the deterioration may be something other than a decline in collectability.

An improvement in the average collection period and turnover rate along with a decrease in the above ratio suggests improved collectability.