What is Average Collection Period?

Average Collection Period Definition

The Average Collection Period (ACP) is a key financial metric used to measure the average number of days a company takes to collect payments from its customers after a sale has been made. It helps businesses evaluate the efficiency of their accounts receivable process and assess how quickly they can convert credit sales into cash. By understanding this metric, companies can better manage cash flow, optimize credit policies, and make informed financial decisions.

Table of Contents

1. Average Collection Period Definition
2. Why is the Average Collection Period Important?
3. Calculating the Average Collection Period
4. How to Improve the Average Collection Period
5. Conclusion

Why is the Average Collection Period Important?

Comprehending the ACP bestows several advantages:

• Cash Flow Management: A diminished ACP translates to swifter access to cash, empowering companies to fulfill expenses, capitalize on growth prospects, and sustain financial equilibrium. Conversely, an elevated ACP can precipitate cash scarcities, impeding the ability to meet financial commitments and affecting business operations.

• Creditworthiness Assessment: Investors and lenders often scrutinize ACP when assessing a company’s creditworthiness. A consistently low ACP can enhance appeal and secure favorable borrowing terms.

• Identifying Bottlenecks: Analyzing the ACP longitudinally can pinpoint areas necessitating enhancement in credit and collection processes. Are invoices dispatched promptly? Are payment terms clearly delineated? Is there a robust follow-up mechanism in place? By rectifying inefficiencies, companies can truncate their ACP and optimize cash flow.

• Benchmarking Performance: Comparing the ACP with industry benchmarks or historical data facilitates the assessment of collection practices vis-à-vis competitors or past performance. This furnishes valuable context for setting improvement objectives and monitoring progress.

Calculating the Average Collection Period

Now, let’s delve into the mechanics of computing the ACP. Two primary methods are employed:

1. Formula-Based Approach:

ACP = (Average Accounts Receivable / Net Credit Sales) * Number of Days in Period

2. Receivables Turnover Ratio:

ACP = 365 (or Number of Days in Period) / Receivables Turnover Ratio

How to Improve the Average Collection Period

1. Streamline Invoicing: Ensure that invoices are sent promptly and accurately, with clear terms and instructions for payment. Automating the invoicing process can help avoid delays.
2. Offer Discounts for Early Payments: Encourage customers to pay sooner by offering early payment discounts or other incentives. This can reduce the Average Collection Period and improve cash flow.
3. Set Clear Credit Policies: Establish clear credit terms and enforce them consistently. This includes setting payment deadlines, offering credit only to qualified customers, and following up on overdue payments promptly.
4. Automate Collections: Use an automated collections system that sends reminders, tracks overdue accounts, and helps prioritize collections efforts. Automation can help businesses stay on top of overdue invoices without wasting time or resources.
5. Evaluate Customer Creditworthiness: Regularly assess the creditworthiness of customers and avoid offering credit to high-risk clients. This can prevent slow payments from affecting your Average Collection Period.

Conclusion

The Average Collection Period is a vital metric that provides valuable insights into a company’s ability to collect payments from customers. By calculating and monitoring this metric, businesses can make informed decisions about their credit policies, improve cash flow, and optimize their accounts receivable process. Regularly improving the Average Collection Period can contribute to a more efficient, profitable, and sustainable business in the long term.

FinFloh can help you reduce your average collection period by 50%. Talk to our team of experts today.