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Originally Posted On: Average collection period: What it is and how to calculate it | QuickBooks (intuit.com)
Every entrepreneur knows that it takes money to make money. But in order to make money, you actually have to collect it. The average collection period, also known as the average collection period ratio (ACP), estimates the timeline a company can expect to collect its accounts receivable. The number of days can vary from business to business depending on things like your industry and customer payment history.
Here, we’ll take a closer look at the average collection period, how to calculate it, and more. Read on for an overview on the topic or use the links below to skip ahead.
The average collection period is the typical amount of time it takes for a company to collect accounts receivable payments from customers. Businesses can measure their average collection period by multiplying the days in the accounting period by their average accounts receivable balance. Then, divide the result by the net credit sales.
Identifying this timeline is especially important for businesses that primarily rely on accounts receivable to fund their cash flow, such as banks, real estate, and construction companies.
First and foremost, establishing your business’s average collection period gives you insight into the liquidity of your accounts receivable assets. In other words, how quickly you can expect to convert credit sales into cash.
Calculating the average number of days it’ll take to get paid allows you to assess the effectiveness of your credit policy. Ultimately, this will help you make more informed financial decisions for your small business.
Every business is unique, so there’s no right answer to differentiate a “good” average collections period from a “bad” one. If your business doesn’t rely heavily on accounts receivable for cash flow, you may be okay with a longer collections period than businesses that need to liquidate credit sales to fund cash flow.
We’ll show you how to analyze your average collection period a little later on in this post.
Now that you know what an ACP is and why it matters, let’s take a look at how to calculate it.
ACP can be found by multiplying the days in your accounting period by your average accounts receivable balance. Then, divide the result by the net credit sales to find the average collections period.
ACP = (Days in Period x Average Accounts Receivable Balance) / Net Credit Sales
Like most accounting metrics, you’ll need some context to determine how this number applies to your finances and collection efforts. In the next section, we’ll show you how to assess your results.
When evaluating your ACP, you want to look at how it stacks up to your credit terms and when you’re actually collecting payment. Let’s take a look at a practical example.
Your business’s credit policy offers net 30 terms, which means you expect customers to pay their invoice within 30 days. If, after calculating your average collection period, you find that you typically receive payment within 30 days, this indicates that you are collecting payment efficiently.
Conversely, if you determine that your average collection period exceeds net 30, you may not be collecting as effectively as you should. As a result, your business may experience issues with cash flow, working capital, or profitability.
In the second scenario, it may be time to rethink your payment terms to aim for a lower average collection period. Let’s take a look at some strategies you can use to improve your accounts receivable turnover ratio.
You can improve your average collection period by reducing the time it takes customers to make payments. Here are a few things you can do to promote timely payments moving forward:
1. Communicate payment terms clearly
Set your expectations for payment, including when the client needs to pay you and the penalties for missing a payment. Transparent payment terms help ensure you get paid, and help your customers understand your billing process. Make payment terms clear on contracts and invoices, with due dates, acceptable payment methods, and other key details included (i.e., “checks are payable to X”).
2. Incentivize early payments
Encourage customers to automate their payments or pay in advance with early payment discounts. You can also consider charging late fees for overdue payments, either as a flat rate or a monthly finance charge, usually a percentage of the overdue amount. A typical late fee is 1% to 1.5% of the total invoiced amount.
3. Follow up proactively
Send customers payment reminders via email to avoid forgotten payments. To make it easier to send these polite reminders, QuickBooks allows you to create automated messages that you can send your clients. If you’re not automating reminders with QuickBooks, starting with a payment reminder template can help you write a professional and friendly payment reminder email.
Create a plan for bad debts
You can create a plan for bad debts using the allowance for doubtful debts. QuickBooks research shows nearly half (44%) of small business owners who experience cash flow issues say the problems were a surprise. A bad debt reserve helps you plan ahead and avoid surprise cash flow problems if late payments become nonpayments. Keeping a business cash reserve can also help you manage your expenses without having to get a loan or stacking up credit card debt when customer payments are delayed.
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