Definition:
The accounts receivable collection period sometime called the day’s sales outstanding simply means the period (number of days) in which credit sales are collected from customers.
This ratio is very important for management to assess the collection performance as well as credit sales assessments.
The account receivable collection period measures the average number of days that credit customers usually make the payment to the company.
The short period of days identified the good performance of collection or credit assessment, and the long period of days represents the long outstanding.
This will subsequently affect the cash flow of the company. The calculation of this ratio involves averages of account receivable and net credit sales. We will discuss this later in this article.
Formula:
Accounts Receivable Collection Period = Average Receivables / (Net Credit Sales / 365 days)
Or
You can calculate The Accounts Receivable Collection Period by
365/Account receivable turnover ratio
- Averaged accounts receivable here are the averages receivable outstanding at the beginning and at the end of the periods. In case you can’t find the averages, the ending balance of receivables could be used instate.
- Net credit sales are the total sales that an entity sold to customers on credit or without immediate payments. As this ratio tries to assess account receivables, cash sales are not applicable.
- Note: When you take Net Credit Sales over 365 days, you will get averaged net credit sales per day. This will be used with averaged accounts receivable to find the period in which accounts receivable are outstanding.
- Another way to calculate the collection period is that you can utilize the account receivable turnover ratio for the calculation. Just divide 365 days with the turnover ratio.
Example:
The company wants to assess the account receivable outstanding at the end of December 2016.
During the year, total credit sales are 1,000,000 USD. The account receivable outstanding at the end of December 2015 is 20,000 USD and at the end of December 2016 is 25,000 USD. Assess the Accounts Receivable Payment Period of the company.
Here is the formula:
Accounts Receivable Payment Period = Average Receivables / (Net Credit Sales / 365 days)
- Net Credit Sales =1,000,000 USD
- Average Receivables = (20,000 + 25,000) / 2 =22,500
Accounts Receivable Payment Period = 22,500 / (1,000,000 / 356) = 8 Days
Explanation:
Based on the calculation above, we noted that the company took an average of 8 days to collect cash from its customers for credit sales. There are no other data for comparison, but 8 days seem quite acceptable.
However, for a fair assessment, comparing this Accounts Receivable Payment Period with another period, competitors or expectations are highly recommended.
The collection period of credit sales is one of the most important key performance indicators that are closely and strictly monitored by the board of directors, CEO, and especially CFO.
This is because of failing in the collection of credit sales or converting the credit sales into cash in a short period of time will adversely affect the company in at least two things.
First, long outstanding accounts receivable could potentially lead to bad debt and the effect is more adverse than the risk of late collection.
This is because the company could not even get the cash from sales of its goods or services but lost them as expenses. This will subsequently lead to poor financial performance.
Second, the company needs cash not only to pay suppliers for the services or products that it purchases for running its operations but also to pay for its employees. Long collection days of credit sales will lead to insufficient cash to pay for these things.
Written by Sinra
