What Is an Average Collection Period?

Average collection period refers to the amount of time it takes for a business to receive payments owed by its clients in terms of accounts receivable (AR). Companies use the average collection period to make sure they have enough cash on hand to meet their financial obligations. The average collection period is an indicator of the effectiveness of a firm’s AR management practices and is an important metric for companies that rely heavily on receivables for their cash flows.

How Average Collection Periods Work

Accounts receivable is a business term used to describe money that entities owe to a company when they purchase goods and/or services. Companies normally make these sales to their customers on credit. AR is listed on corporations’ balance sheets as current assets and measures their liquidity. As such, they indicate their ability to pay off their short-term debts without the need to rely on additional cash flows.

The average collection period is an accounting metric used to represent the average number of days between a credit sale date and the date when the purchaser remits payment. A company’s average collection period is indicative of the effectiveness of its AR management practices. Businesses must be able to manage their average collection period to operate smoothly.

A lower average collection period is generally more favorable than a higher one. A low average collection period indicates that the organization collects payments faster. However, this may mean that the company’s credit terms are too strict. Customers who don’t find their creditors’ terms very friendly may choose to seek suppliers or service providers with more lenient payment terms.

Formula for Average Collection Period

Average collection period is calculated by dividing a company’s average accounts receivable balance by its net credit sales for a specific period, then multiplying the quotient by 365 days.

Average Collection Period = 365 Days * (Average Accounts Receivables / Net Credit Sales)

Alternatively and more commonly, the average collection period is denoted as the number of days of a period divided by the receivables turnover ratio. The formula below is also used referred to as the days sales receivable ratio.

Average Collection Period = 365 Days / Receivables Turnover Ratio

The average receivables turnover is simply the average accounts receivable balance divided by net credit sales; the formula below is simply a more concise way of writing the formula.

Average Accounts Receivables

For the formulas above, average accounts receivable is calculated by taking the average of the beginning and ending balances of a given period. More sophisticated accounting reporting tools may be able to automate a company’s average accounts receivable over a given period by factoring in daily ending balances.

When analyzing average collection period, be mindful of the seasonality of the accounts receivable balances. For example, analyzing a peak month to a slow month by result in a very inconsistent average accounts receivable balance that may skew the calculated amount.

Net Credit Sales

Average collection period also relies on net credit sales for a period. This metric should exclude cash sales (as those are not made on credit and therefore do not have a collection period).

In addition to being limited to only credit sales, net credit sales exclude residual transactions that impact and often reduce sales amounts. This includes any discounts awarded to customers, product recalls or returns, or items re-issued under warranty.

Importance of Average Collection Period

Average collection period boils down to a single number; however, it has many different uses and communicates a variety of important information.

• It tells how efficiently debts are collected. This is important because a credit sale is not fully completed until the company has been paid. Until cash has been collected, a company is yet to reap the full benefit of the transaction.
• It tells how strict credit terms are. This is important as strict credit terms may scare clients away; on the other hand, credit terms that are too loose may attract customers looking to take advantage of lenient payment terms.
• It tells how competitors are performing. This is important because all figures needed to calculate the average collection period are available for public companies. This gives deeper insight into what other companies are doing and how a company’s operations compare.
• It tells early signals of bad allowances. This is important because as the average collection period increases, more clients are taking longer to pay. This metric can be used to signal to management to review its outstanding receivables at risk of being uncollected to ensure clients are being monitored and communicated with.
• It tells of a company’s short-term financial health. This is important because without cash collections, a company will go insolvent and lack the liquidity to pay its short-term bills.

How to Use Average Collection Period

The average collection period does not hold much value as a stand-alone figure. Instead, you can get more out of its value by using it as a comparative tool.

The best way that a company can benefit is by consistently calculating its average collection period and using it over time to search for trends within its own business. The average collection period may also be used to compare one company with its competitors, either individually or grouped together. Similar companies should produce similar financial metrics, so the average collection period can be used as a benchmark against another company’s performance.

Companies may also compare the average collection period with the credit terms extended to customers. For example, an average collection period of 25 days isn’t as concerning if invoices are issued with a net 30 due date. However, an ongoing evaluation of the outstanding collection period directly affects the organization’s cash flows.

Example of Average Collection Period

As noted above, the average collection period is calculated by dividing the average balance of AR by total net credit sales for the period, then multiplying the quotient by the number of days in the period.

Let’s say a company has an average AR balance for the year of $10,000. The total net sales that the company recorded during this period was $100,000. We would use the following average collection period formula to calculate the period:

($10,000 ÷ $100,000) × 365 = Average Collection Period

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The average collection period, therefore, would be 36.5 days. This is not a bad figure, considering most companies collect within 30 days. Collecting its receivables in a relatively short and reasonable period of time gives the company time to pay off its obligations.

If this company’s average collection period was longer—say, more than 60 days— then it would need to adopt a more aggressive collection policy to shorten that time frame. Otherwise, it may find itself falling short when it comes to paying its own debts.

Accounts Receivable (AR) Turnover

The average collection period is closely related to the accounts turnover ratio, which is calculated by dividing total net sales by the average AR balance.

Using the previous example, the AR turnover is 10 ($100,000 ÷ $10,000). The average collection period can also be calculated by dividing the number of days in the period by the AR turnover. In this example, the average collection period is the same as before: 36.5 days.

365 days ÷ 10 = Average Collection Period

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Collections by Industries

Not all businesses deal with credit and cash in the same way. Although cash on hand is important to every business, some rely more on their cash flow than others.

For example, the banking sector relies heavily on receivables because of the loans and mortgages that it offers to consumers. As it relies on income generated from these products, banks must have a short turnaround time for receivables. If they have lax collection procedures and policies in place, then income would drop, causing financial harm.

Real estate and construction companies also rely on steady cash flows to pay for labor, services, and supplies. These industries don’t necessarily generate income as readily as banks, so it’s important that those working in these industries bill at appropriate intervals, as sales and construction take time and may be subject to delays.

The Bottom Line

The average collection period is the average number of days it takes for a credit sale to be collected. During this period, the company is awarding its customer a very short-term “loan”; the sooner the client can collect the loan, the earlier it will have the capital to use to grow its company or pay its invoices. While a shorter average collection period is often better, too strict of credit terms may scare customers away.

What Is Accounts Receivable Financing?

Accounts receivable (AR) financing is a type of financing arrangement in which a company receives financing capital related to a portion of its accounts receivable. Accounts receivable financing agreements can be structured in multiple ways usually with the basis as either an asset sale or a loan.

Understanding Accounts Receivable Financing

Accounts receivable financing is an agreement that involves capital principal in relation to a company’s accounts receivables. Accounts receivable are assets equal to the outstanding balances of invoices billed to customers but not yet paid. Accounts receivables are reported on a company’s balance sheet as an asset, usually a current asset with invoice payment required within one year.

Accounts receivable are one type of liquid asset considered when identifying and calculating a company’s quick ratio which analyzes its most liquid assets:

Quick Ratio = (Cash Equivalents + Marketable Securities + Accounts Receivable Due within One Year) / Current Liabilities

As such, both internally and externally, accounts receivable are considered highly liquid assets which translate to theoretical value for lenders and financiers. Many companies may see accounts receivable as a burden since the assets are expected to be paid but require collections and can’t be converted to cash immediately. As such, the business of accounts receivable financing is rapidly evolving because of these liquidity and business issues. Moreover, external financiers have stepped in to meet this need.

The process of accounts receivable financing is often known as factoring and the companies that focus on it may be called factoring companies. The best factoring companies will usually focus substantially on the business of accounts receivable financing but factoring in general may be a product of any financier. Financiers may be willing to structure accounts receivable financing agreements in different ways with a variety of different potential provisions.​

Structuring

Accounts receivable financing is becoming more common with the development and integrations of new technologies that help to link business accounts receivable records to accounts receivable financing platforms. In general, accounts receivable financing may be slightly easier for a business to obtain than other types of capital financing. This can be especially true for small businesses that easily meet accounts receivable financing criteria or for large businesses that can easily integrate technology solutions.

Overall, there are a few broad types of accounts receivable financing structures.

Asset Sales

Accounts receivable financing is typically structured as an asset sale. In this type of agreement, a company sells accounts receivable to a financier. This method can be similar to selling off portions of loans often done by banks.

A business receives capital as a cash asset replacing the value of the accounts receivable on the balance sheet. A business may also need to take a write-off for any unfinanced balances which would vary depending on the principal to value ratio agreed on in the deal.

Depending on the terms, a financier may pay up to 90% of the value of outstanding invoices. This type of financing may also be done by linking accounts receivable records with an accounts receivable financier. Most factoring company platforms are compatible with popular small business bookkeeping systems such as Quickbooks. Linking through technology helps to create convenience for a business, allowing them to potentially sell individual invoices as they are booked, receiving immediate capital from a factoring platform.

With asset sales, the financier takes over the accounts receivable invoices and takes responsibility for collections. In some cases, the financier may also provide cash debits retroactively if invoices are fully collected.

Most factoring companies will not be looking to buy defaulted receivables, rather focusing on short-term receivables. Overall, buying the assets from a company transfers the default risk associated with the accounts receivables to the financing company, which factoring companies seek to minimize.

In asset sale structuring, factoring companies make money on the principal to value spread. Factoring companies also charge fees which make factoring more profitable to the financier.

BlueVine is one of the leading factoring companies in the accounts receivable financing business. They offer several financing options related to accounts receivable including asset sales. The company can connect to multiple accounting software programs including QuickBooks, Xero, and Freshbooks. For asset sales, they pay approximately 90% of a receivables value and will pay the rest minus fees once an invoice has been paid in full. 

Loans

Accounts receivable financing can also be structured as a loan agreement. Loans can be structured in various ways based on the financier. One of the biggest advantages of a loan is that accounts receivable are not sold. A company just gets an advance based on accounts receivable balances. Loans may be unsecured or secured with invoices as collateral. With an accounts receivable loan, a business must repay.

Companies like Fundbox, offer accounts receivable loans and lines of credit based on accounts receivable balances. If approved, Fundbox can advance 100% of an accounts receivable balance. A business must then repay the balance over time, usually with some interest and fees.

Accounts receivable lending companies also benefit from the advantage of system linking. Linking to a companies accounts receivable records through systems such as QuickBooks, Xero, and Freshbooks, can allow for immediate advances against individual invoices or management of line of credit limits overall.

Underwriting

Factoring companies take several elements into consideration when determining whether to onboard a company onto its factoring platform. Furthermore, the terms of each deal and how much is offered in relation to accounts receivable balances will vary.

Accounts receivables owed by large companies or corporations may be more valuable than invoices owed by small companies or individuals. Similarly, newer invoices are usually preferred over older invoices. Typically, the age of receivables will heavily influence the terms of a financing agreement with shorter term receivables leading to better terms and longer term or delinquent receivables potentially leading to lower financing amounts and lower principal to value ratios.

Advantages and Disadvantages

Accounts receivable financing allows companies to get instant access to cash without jumping through hoops or dealing with long waits associated with getting a business loan. When a company uses its accounts receivables for asset sales it does not have to worry about repayment schedules. When a company sells its accounts receivables it also does not have to worry about accounts receivable collections. When a company receives a factoring loan, it may be able to obtain 100% of the value immediately.

Although accounts receivable financing offers a number of diverse advantages, it also can carry a negative connotation. In particular, accounts receivable financing can cost more than financing through traditional lenders, especially for companies perceived to have poor credit. Businesses may lose money from the spread paid for accounts receivables in an asset sale. With a loan structure, the interest expense may be high or may be much more than discounts or default write-offs would amount to.

What Are Accounts Receivable (AR)?

Accounts receivable (AR) are the balance of money due to a firm for goods or services delivered or used but not yet paid for by customers. Accounts receivable are listed on the balance sheet as a current asset. Any amount of money owed by customers for purchases made on credit is AR.

Understanding Accounts Receivable

Accounts receivable refer to the outstanding invoices that a company has or the money that clients owe the company. The phrase refers to accounts that a business has the right to receive because it has delivered a product or service. Accounts receivable, or receivables, represent a line of credit extended by a company and normally have terms that require payments due within a relatively short period. It typically ranges from a few days to a fiscal or calendar year.

Companies record accounts receivable as assets on their balance sheets because there is a legal obligation for the customer to pay the debt. They are considered a liquid asset, because they can be used as collateral to secure a loan to help meet short-term obligations. Receivables are part of a company’s working capital.

Furthermore, accounts receivable are current assets, meaning that the account balance is due from the debtor in one year or less. If a company has receivables, this means that it has made a sale on credit but has yet to collect the money from the purchaser. Essentially, the company has accepted a short-term IOU from its client.

Accounts Receivable vs. Accounts Payable

When a company owes debts to its suppliers or other parties, these are accounts payable. Accounts payable are the opposite of accounts receivable. To illustrate, imagine Company A cleans Company B’s carpets and sends a bill for the services. Company B owes them money, so it records the invoice in its accounts payable column. Company A is waiting to receive the money, so it records the bill in its accounts receivable column.

Benefits of Accounts Receivable

Accounts receivable are an important aspect of a business’s fundamental analysis. Accounts receivable are a current asset, so it measures a company’s liquidity or ability to cover short-term obligations without additional cash flows. 

Fundamental analysts often evaluate accounts receivable in the context of turnover, also known as accounts receivable turnover ratio, which measures the number of times a company has collected on its accounts receivable balance during an accounting period. Further analysis would include assessing days sales outstanding (DSO), the average number of days that it takes to collect payment after a sale has been made.

Example of Accounts Receivable

An example of accounts receivable includes an electric company that bills its clients after the clients received the electricity. The electric company records an account receivable for unpaid invoices as it waits for its customers to pay their bills. 

Most companies operate by allowing a portion of their sales to be on credit. Sometimes, businesses offer this credit to frequent or special customers that receive periodic invoices. The practice allows customers to avoid the hassle of physically making payments as each transaction occurs. In other cases, businesses routinely offer all of their clients the ability to pay after receiving the service.