Small businesses use a variety of financial ratios and metrics to determine whether they’re in good financial health. One such metric is your company’s average collection period formula, also known as days sales outstanding.
This metric tells you how long it takes to get paid by customers, and it can help ensure you have enough cash flow to pay employees, make loan payments, and pay other expenses.
In this article, we’ll show you how to calculate your company’s average collection period and give you some examples of how to use it.
Defining Average Collection Period
The average collection period is the average number of days it takes to collect payments from your customers.
When you extend credit terms to clients, the amount they owe you becomes part of your accounts receivable balance. Performing an average collection period calculation tells you how long it takes, on average, to turn your receivables into cash.
Average Collection Period Formula
The formula for calculating your average collection period is:
Average Collection Period = (Average Accounts Receivable Balance / Net Credit Sales) x 365
First, calculate your average accounts receivable (AR) balance for that year. You do this by adding your beginning and ending AR balances and dividing by two.
Starting with the average AR balance gives you a better snapshot of the year. If you were to simply use your ending AR balance, your results might be skewed by a particularly large or small year-end balance.
Next, divide your average AR balance by your total net credit sales. You only include credit sales in this calculation, not total sales. You leave cash sales out of the formula because cash sales don’t affect your accounts receivables balance.
Finally, you multiply the result by 365—the number of days in a year.
You can find the inputs for this formula on your financial statements, like your balance sheet and income statement.
Example of Calculating Your Average Collection Period
Here’s an example so you can see the formula in action.
Let’s say you own an electrical contracting business called Light Up Electric. At the beginning of the year, your accounts receivable (AR) on your balance sheet was $39,000. At the end of the year, your AR balance was $42,000.
Your total net credit sales for the year, which you can find on your income statement, were $850,000.
Step 1: Calculate Your Average Accounts Receivable
The first step in calculating your average collection period is to find your average accounts receivable. To do this, you take the sum of your starting and ending receivables for the year and divide it by two.
Light Up Electric’s average AR would be:
Average Accounts Receivable = (Beginning AR + Ending AR) / 2
($39,000 + $42,000) / 2 = $40,500
Step 2: Calculate Your Average Collection Period
Now, you can plug your average AR into the average collection period formula:
Average Collection Period = (Average Accounts Receivable Balance / Net Credit Sales) x 365
($40,500 / $850,000) x 365 = 17.39
This means Light Up Electric’s average collection period for the year is about 17 days.
Other Ways to Calculate Your Average Collection Period Ratio
There is an alternative formula for calculating your average collection period, but the results will be the same. Some companies use the following formula:
(Days x Average Accounts Receivable) / Net Credit Sales
Example
Let’s use that formula for Light Up Electric to show how you’d get the same results:
(365 x $40,500) / $850,000 = 17.39
Either way you calculate it, you wind up with the same result. On average, it takes Light Up Electric just over 17 days to collect outstanding receivables.
Calculating Collection Period for Different Lengths of Time
You can also calculate your average collection period for another period of time, such as a month or a quarter. To do that, you need to:
- Calculate your average receivables for the month or quarter rather than the year
- Use the number of days in the period instead of 365
- Use your net sales for the month or quarter
Example
For example, say you want to find Light Up Electric’s average collection period ratio for January. At the beginning of the month, your beginning balance of accounts receivable was $42,000, and your ending accounts receivable balance was $51,000. Net sales for the month were $200,000.
Your calculation would be:
((($42,000 + $51,000)/2) / $200,000) x 30 = 6.98
In January, it took Light Up Electric almost seven days, on average, to collect outstanding receivables.
What Can You Do with This Metric?
Now that you know how to calculate your average collection period ratio, what do you do with it?
Well, the first thing you should do is compare it to your credit policies.
For example, if your credit terms call for customers to pay their invoices within 15 days, then an average collection period of 17 days isn’t terrible, but it indicates that some clients are taking a little longer to pay than you’d like.
On the other hand, if your invoices are Net 30—meaning payment is due 30 days from the invoice date—and clients are paying within 17 days, then you have a lower average collection period than your payment terms call for. Clearly, your clients have no problems paying you on time—even early in many cases!
Benefits of Calculating Your Average Collection Period
Here is why calculating your average collection period can help your business’s financial health.
Improve Liquidity
Liquidity is your business’s ability to convert assets into cash to pay your short-term liabilities or debts.
If you have difficulty collecting customer payments, it’s tough to pay employees, make loan payments, and take care of other bills. So monitoring the time frame for collecting AR allows you to maintain the cash flow necessary to cover those costs.
Another helpful metric for monitoring liquidity is net working capital, which is the difference between your current assets and current liabilities.
Evaluate Your Collection Policies
Your average collection period refers to the amount of time it takes you to collect cash from credit sales. If you have an extended collection period, you may need to change your credit and collection policies.
Some ways to improve your average collection period include:
- Include payment deadlines in contracts and on invoices
- Make it easy for clients to pay by offering multiple payment options, including credit card and bank transfer
- Automate reminders when invoices are approaching their due date
- Call clients to check on the status of their payment as soon as their account is past due
- Consider offering an early payment discount or charging late fees
- Require upfront deposit or payment in full from chronically late customers
Compare Your Performance to Industry Averages
When you know your average collection period, you can compare your results to other businesses in your industry and see whether there’s room for improvement.
For example, according to Lockstep: foundation, structure, and building exterior contractors have an average collection period of 67.5 days. If your average collection period is much higher, you know that many of your competitors are collecting receivables faster than you are. That might give them more leverage to scale faster than you—since they’ll have the cash on hand sooner.
On the other hand, if your results are better than average, you know you’re operating efficiently, and cash flow might be a competitive advantage.
Get an Early Warning Sign for Uncollectible Accounts
Monitoring your average collection period regularly can help you spot problem accounts before they become uncollectible.
The longer a receivable goes unpaid, the less likely you are to be able to collect from that customer. So if you calculate your average collection period each month and see the number creeping up over time, you should review your AR aging report in more detail to see if any balances are seriously delinquent and at risk of becoming uncollectible.
Average Collection Period vs. Accounts Receivable Turnover Ratio
Your average collection period ratio is closely related to another useful metric: your accounts receivable turnover ratio. Both of these metrics measure how successful you are at collecting receivables. However, your AR turnover ratio tells you how many times you convert receivables into cash during a given accounting period.
The formula for calculating AR turnover is:
Net Credit Sales / Average Accounts Receivable = Accounts Receivable Turnover
Using the same figures for Light Up Electric, we can calculate the company’s AR turnover ratio as follows:
$850,000 / $40,500 = 20.98
In other words, Light Up Electric “turned over”—i.e., converted its AR into cash—21 times during the year.
In general, a higher receivable turnover is better because it means customers pay their invoices on time. So Light Up Electric should compare its AR Turnover Ratio to the industry average to see how they’re doing.
Limitations of This Formula
While the collection period formula is useful for measuring how efficiently you collect receivables, it has its limitations.
Because it represents an average, customers who pay very early or extremely late can skew your results.
It also looks at your average across your entire customer base, so it won’t help you spot specific clients that might be at risk of default. You’ll need to monitor your accounts receivable aging report for that level of insight.
Use Your Average Collection Period to Keep Your Company in the Green
The average collection period is an important metric for keeping your cash flow strong and ensuring your collection policies are effective.
Now that you know how to make the average collection period calculation and how to use it, pull up your financial statements and see where you stand!
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