How to Calculate Average Collection Period in Days
Calculating the average collection period in days is a crucial step for businesses to assess their efficiency in managing receivables. This metric helps companies understand how long it takes on average to collect payments from customers, which can provide valuable insights into cash flow management and credit policies. In this article, we will discuss the importance of the average collection period and guide you through the process of calculating it.
The average collection period, also known as the days sales outstanding (DSO), measures the average number of days it takes for a company to collect payment after a sale has been made. This metric is essential for businesses as it helps them identify potential issues with their receivables and take necessary actions to improve their cash flow. A longer average collection period can indicate inefficiencies in the credit and collection processes, while a shorter period can suggest effective management practices.
To calculate the average collection period in days, follow these steps:
1. Determine the total accounts receivable at the end of a specific period, typically a month or a year. This can be found on the balance sheet.
2. Calculate the net credit sales for the same period. Net credit sales can be obtained from the income statement by subtracting any returns, allowances, or discounts from the total credit sales.
3. Find the average accounts receivable for the period. This can be done by adding the beginning and ending accounts receivable balances and dividing the sum by two.
4. Divide the average accounts receivable by the net credit sales to get the accounts receivable turnover ratio.
5. Finally, multiply the accounts receivable turnover ratio by the number of days in the period to calculate the average collection period in days.
Here’s an example to illustrate the calculation:
Assuming a company has the following information for the year 2021:
– Total accounts receivable at the end of the year: $500,000
– Net credit sales for the year: $1,000,000
– Average accounts receivable for the year: ($300,000 + $500,000) / 2 = $400,000
Now, let’s calculate the average collection period in days:
1. Accounts receivable turnover ratio = Average accounts receivable / Net credit sales = $400,000 / $1,000,000 = 0.4
2. Average collection period in days = Accounts receivable turnover ratio Number of days in the period = 0.4 365 = 146 days
Based on this calculation, the company takes an average of 146 days to collect payments from customers after a sale has been made.
In conclusion, calculating the average collection period in days is a vital process for businesses to evaluate their receivables management. By understanding this metric, companies can identify areas for improvement and take necessary actions to optimize their cash flow. Keep in mind that the average collection period may vary across different industries and business models, so it’s essential to compare it with industry benchmarks and historical data for a more accurate assessment.
