An average collection period is a valuable performance parameter in accounting. It’s mostly used for analysis as one of the many comparative indicators. Comparing a company’s ACP against that of the competition or its own historical data will give you an idea of how well-oiled the business’ financial machine is.
In short, the average collection period shows how fast the company can collect the money owed to them by the clients. Lower ACP means it doesn’t take long for the specific business to receive money from the sales done on credit, while higher ACP means some time will pass before that happens.
Counting this indicator is a simple enough task. Essentially, ACP shows the time needed on average for the company to receive the money for something they sold on credit. A sale on credit is a sale that doesn’t charge money immediately. Clients can pay for these at a later date. The usual cash sales aren’t taken into account here.
There’s a formula meant to ascertain how much that is for a particular business. It looks like this:
days in the year / accounts receivable turnover ratio = ACP
That ratio is a likewise valuable indicator. It usually shows how many times in the year the company managed to reach their average monthly value of accounts receivable in all credit sales made that year. Put simply, it shows how quickly the business can receive their usual amount of money.
It’s the same concept, and the two indicators are tightly connected. The turnover ratio determines the averaged speed because accounts receivable can vary from month to month. But you also need to locate the total size of sales on credit for the year.
Let us say that, one year, the business made sales worth $120,000. If the average accounts receivable size is $10,000 for a month, then it’s an even speed of 12. It means that it takes about a month or 30 days (365/12) to receive the money from the sales made on credit. The number ‘12’ here is the ratio, while the ’30 days’ part is the average collection period.
Naturally, it’s almost never this even. Accounts receivable vary from month to month. It’s important to remember that this number on its own isn’t bad or good. For analytical purposes, it should be compared to the ACP of other businesses in the industry.
What use is it?
For the purposes of investing or analyzing, the goal of determining these periods is to assess the efficiency of the company’s management. It mainly just shows how quickly the accounts receivable are processed, but it can reflect the general state and performance of the business, especially when used in conjunction with other indicators.
This can then give you an idea of the company’s overall management efficiency. It can then be used to decide whether you want to buy their shares or not.
For companies, the purpose is more practical. A small average collection period means businesses can collect cash on short notice. Consequently, they can be more confident when it comes to paying back their own debts. It’s a good instrument of planning, if anything.