What is Average Collection Period?
In order to calculate average collection period (ACP), we must first define what it is. The average collection period is an accounting metric used to represent the amount of time it takes for a business to receive payments owed by its clients in terms of accounts receivable.
ACP is best examined on a trend line, to see if there are any long-term changes. In a business where sales are steady and the customer mix is unchanging, it should be quite consistent from period to period. Conversely, when sales or the mix of customers is changing dramatically, this measure can be expected to vary substantially over time.
An increase in the ACP can be indicative of any of the conditions below and they are;
- Looser credit policy. This is when the management decides to grant more credit to customers in an effort to increase sales. It may also mean that certain customers are being allowed a longer period of time before they must pay for outstanding invoices.
- A worsening economy. General economic conditions could be impacting customer cash flows, requiring them to delay payments to their suppliers.
- Reduced collection efforts. A decline in the funding for the collections department or an increase in the staff turnover of this department. In either case, less attention is paid to collections, resulting in an increase in the amount of receivables outstanding
A decrease in the average collection period can be indicative of any of the conditions below;
- Tighter credit policy. This is when the management restricts the granting of credit to customers because of reasons like economic condition etc.
- The imposition of shorter payment terms on customers. This is when a company imposes shorter payment terms on its customers.
- A more active collections department. This is when the management decides to increase the staffing and technology support of the collections department, which results in a reduction in the amount of overdue accounts receivable.
Importance of the ACP.
- It enables the company to maintain a level of liquidity, which allows it to pay for immediate expenses and to get a general idea of when it may be capable of making larger purchases.
- ACP help a company prepare an effective plan for covering costs and scheduling potential expenditures to further growth.
- The average collection period shows the average number of days necessary to convert business receivables into cash.
- The average collection period may also be used to compare one company with its competitors, either individually or grouped together.
Formula to Calculate Average Collection Period.
Suppose the average account receivables per day of a grocery store is $50,000 while the average credit sales per day is $20,000. Calculate the average collection period.
Therefore, the average collection period is 2.5.