Average Collection Period Ratio

To sustain the functioning of any business process, a steady cash inflow needs to be maintained. For that to happen, the delicate balance between income and expenses has to be maintained. Even though goods are produced and sold, there is usually a lag between the sales and actual cash received from the customers.

This lag is reflected in the rate at which the accounts receivables are converted into actual cash inflows. The average time period required to collect payments for goods and services, sold by a business, is called the average collection period ratio. The parameters which decide this ratio are the average accounts receivables generated in a year and the credit sales made by the business in a specific time period.

The ratio varies according to the nature of the business and the types of goods and/or services offered. When a business gets paid for its service immediately and credit sale is high, the collection period ratio will certainly be short. On the other hand, if the total credit sale of a business is low, the collection period will be longer.

The more rapidly accounts receivables are converted into actual cash inflow, better is the liquidity made available for the business. In short, it increases the operational pace of the cash conversion cycle. A high liquidity lets a business pursue developmental projects and effectively sustains the business process.

Average Collection Period Ratio = (Accounts Receivable) x (Business Cycle Period)/(Total Credit Sale)

The business cycle period may vary from a year to any length of time, which is less than a year. It all depends on how you want to segment the time period of your business cycle. 

The accounts receivable may increase or decrease throughout the year, as payments are received and new sales are made. In general accounting practice, the average of the account receivable entries on the first and last day of the business cycle is taken into consideration.

The total credit sales made by the business during that period is the biggest determining factor, when it comes to calculating the period.

An example will make it easy for you to understand the calculation. Consider that a business had an average accounts receivable of USD 1,000,000 in a period of 300 days, during which its total credit sales were USD 3,000,000. Substituting the values in the above formula:

Average Collection Period = (1000000 x 300 days) / (3000000) = 100 days

An analysis of this collection period is necessary to give you an idea about the time taken by the business to generate actual cash flows over the period of a year. This can help you make necessary changes in your business process, to make it smoother and more efficient.