collection period
Dictionary of Accounting Terms
number of days it takes to collect accounts receivable. The collection period should be or can be compared to the terms of sale. A long collection period may indicate higher risk in collecting the account; it ties up funds that could be invested elsewhere or used to make timely payments. It equals the number of days in a year divided by the accounts receivable turnover . Assume a 360-day year and turnover rate of 10 times. The collection period is 36 days.
period of time required to convert deposited checks into collected balances. The Expedited Funds Availability Act of 1987 requires banks to credit funds to a customer's account within two days from the date of deposit for local checks, and within five days for nonlocal checks.
Related Terms:
classifying accounts by the time elapsed after the date of billing or the due date. The longer a customer's account remains uncollected or the longer inventory is held, the greater is its realization risk. If a customer's account is past due, the company also has an opportunity cost of funds tied-up in the receivable that could be invested elsewhere for a return. An aging schedule of accounts receivable may break down receivables from 1-30 days, 31-60 days, 61-90 days, and over 90 days. With regard to inventory, if it is held too long, obsolescence, spoilage, and technological problems may result. Aging can be done for other accounts such as fixed assets and accounts payable.
ratio of a company's accounts receivable to its average daily sales. Average daily sales are obtained by dividing sales for an accounting period by the number of days in the accounting period-annual sales divided by 365, if the accounting period is a year. That result, divided into accounts receivable (an average of beginning and ending accounts receivable is more accurate), is the collection ratio-the average number of days it takes the company to convert receivables into cash. It is also called average collection period.
table showing the number of days needed to clear a deposited check. Under the expedited funds availability act, financial institutions must give their customers access to deposited funds within a fixed number of days, depending on whether a check is drawn on a local or nonlocal bank. Local checks (checks deposited at a bank in the same Federal Reserve Regional Check Processing Center as the paying bank) must be available for use within two business days after the day of deposit.
Understanding Accounting
Terms and Accounting Definitions
Accounting terms make up the language of business to measure business performance and profitability. The following accounting dictionary of key accounting terms and accounting definitions decodes the language of business with easy to follow illustrations and examples.
For a more in depth discussion of each accounting definition, simply click the link associated with each term.
The Accounting Cycle is a ten step process that consists of the procedures necessary to collect, process, and report economic events that affect an entity during a reporting period (e.g. a month, a quarter, or a year).
Accounting Equation refers to the main accounting formula that lays the foundation of double-entry accounting, where a debit on one side of the equation must equal a credit on the other side. The Accounting Equation also represents the relationship of financial elements on the Balance Sheet to each other:
Assets = Liabilities + Owner's Equity
Accounts Receivable Definition- the current asset listed on the balance sheet that shows the amount owed to the company from customers who purchased products or services on credit.
Accounts Receivable Turnover measures how quickly a business collects cash for sales on credit, or "turned over" the Accounts Receivable Balance, for the accounting period measured. Accounts Receivable Turnover is calculated as
Net Credit Sales/Average Net Receivables
where Average Receivables = (Beginning Net Receivables Balance + Ending Net Receivables Balance)/2
or as (year example) 365/Average Collection Period:
Average Sales Per Day = Credit Sales or Total Sales/365
Average Collection Period = Accounts Receivable/Average Sales Per Day
Accrual Accounting Method is an accounting term that refers to the method of recognizing and reporting revenues when earned, whether or not cash is actually received, and expenses when incurred, whether or not cash is actually paid. Compare with the accounting term Cash Accounting Method.
Accumulated depreciation is an accounting term that refers to the total depreciation expense taken from year to year. Accumulated depreciation accumulates on the balance sheet from period to period as a contra asset account, where it is subtracted from the original cost of the asset to get its book value.
Adjusting Journal Entries are accounting entries made at the end of an accounting period (e.g. a month, a quarter, or a year) to report transactions that occurred but were not recorded during the normal course of business. Adjusting Journal Entries are necessary to more accurately represent the financial statements for the reporting period. Adjusting Journal Entries are classified as Prepayments, Accruals, and Estimated Items.
Aging of Accounts Receivable bases the estimate for uncollectible accounts on the Ending Accounts Receivable balance and the computation that the longer an account is outstanding, the higher the likelihood that it will not be collected.
Accounts Receivable Turnover
and Average Collection Period
Accounts receivable turnover allows a company to measure whether or not the company is effectively collecting payments for sales on credit.
A high turnover indicates higher cash basis sales or efficient collections. A low turnover indicates collection problems and possible bad debts.
Most companies do not charge interest on accounts receivable unless the account becomes past due. An extension of credit is then essentially an interest free loan to customers, and not collecting payments on time creates inefficiency and opportunity costs for the company. For example, the company could use the cash to invest the money and earn interest, pay down debt from which the company is incurring interest expenses, or finance growth opportunities instead of having money tied up in accounts receivable.
So why sell products on credit in the first place?
Firms expect that by selling on credit, they can achieve better sales and profits than they would if their sales were on a cash basis only. Even though a firm runs the risk of not being able to collect on some receivables, it expects that these uncollectible accounts and associated costs of credit sales will be sufficiently offset by an increase in sales and, in turn, an increase in net income.
To encourage prompt payment, companies may offer sales discounts. For example, a company may offer "2%/10, net 30." This means if a customer purchases products and pays within 10 days, they can take 2% off the total price. Otherwise full payment is due within 30 days.
Customers should always take advantage of the 2% discount offered in the credit terms, even if they have to borrow money during the 10 day discount period. The loss of the 2% discount in exchange for an extra 20 days to pay is equivalent to a 36% annual interest rate (2% times the number of 20 day periods in one year or 360/20 = 18 x 2% = 36%).
Nonetheless, it is a business risk that a certain percentage of customers will not pay balances due at all, so measures of uncollectible accounts should be made when it can be reasonably estimated. Estimates are usually based on historical uncollectibles.
Since Sunny Sunglasses is new in the business, it has estimated that roughly 1% of credit sales will be uncollectible based on industry averages. This comes out to approximately $700 a year, as seen on the sample income statement and the examples of balance sheets.
Accounts Receivable Turnover Calculation:
Net Credit Sales/Average Net Receivables
where net average receivables = (beginning net receivables balance + ending net receivables Balance)/2
Net receivables at year end equals $21,200. Since Sunny Sunglasses Shop started business in January of 2007, there is no beginning balance. Sunny knows that his net credit sales for the year were $70,000.
Plugging the numbers into the formula, we get 6.6.
Calculating Accounts Receivable Turnover
70,000/10,600 = 6.6
where Average Receivables = (0 + 21,200)/2 = 10,600
Alternatively, businesses may calculate accounts receivable turnover in a two step process as follows:
Calculating the Average Collection Period
1. Average Sales Per Day = Credit Sales or Total Sales/365
2. Average Collection Period = Accounts Receivable/Average Sales Per Day
Average Collection Period Example
1. Average Sales Per Day = 144,000/365 = $395
2. Average Collection Period = 21,200/395 = 54 Days
In both accounts receivable turnover and average collection period calculations above, accounts receivable is net receivables, i.e. accounts receivable less any allowance for bad debts. However, the average collection period uses the last known accounts receivable balance for the period.
Average Collection Period and Accounts Receivable Turnover
The average collection period can be translated to accounts receivable turnover by dividing the number of days a year by the average collection period, or 365/54 = 6.8
Since many companies do not disclose total sales on credit, users of financial statements may use this method to determine accounts receivable turnover using total sales. When comparing turnover ratios, make sure that the same sales type is used when calculating receivable turnovers (credit sales or total sales).
The next step is to add meaning to these numbers by comparing them with the industry averages:
| Company | Accounts Receivable Turnover | Days Outstanding |
| Microsoft | 5.4 | 66 Days |
| Software Industry | 6.4 | 57 Days |
| Specialty Retail, Other | 24.3 | 15 Days |
| Sunglasses Hut Int. (Luxottica Group) | 8.8 | 41 Days |
| Sunny Sunglasses Shop | 6.8 | 54 Days |
| S&P 500 | 9.5 | 38 Days |
Sunny Sunglasses has an average collection period of 54 days after one year of operations. It also has a low accounts receivable turnover ratio compared to its main competitor and especially the industry average. Sunny's accounts receivable account balance should not be increasing very much over the course of the year if the company is to remain within industry standards.
If Sunny Sunglasses has an Achilles Heel in its profitable operations, it may be the low accounts receivable turnover.
In fact, we can check what the balance of accounts receivable should be throughout the year to stay competitive with industry standards.
Simply use the average collection period above to calculate what the accounts receivable balance should be to stay within a given collection period (e.g. 15 days, 30 days, 45 days, 60 days, or 90 days).
If the Average Collection Period = Accounts Receivable Balance/Average Sales per day,
then Average Collection Period x Average Sales per Day = Accounts Receivable Balance.
Average Collection Period Days x $395 = Accounts Receivable Balance.
$395 x Average Collection Period Days = AR Balance
| # of Collection Days | Accounts Receivable Balance |
| 15 Days | $6,000 |
| 30 Days | $12,000 |
| 45 Days | $18,000 |
| 60 Days | $24,000 |
| 90 Days | $36,000 |
If payment terms are within 60 days, the balance needs to stay at or under $24,000 assuming sales average $395 a day. To stay competitive with the industry average for specialty retail of 15 collection days, the accounts receivable balance should be approximately $6,000 with average sales of $395 a day. Greater sales allow for higher receivable balances within the collection time frames.
Sunny should monitor accounts receivable balances during the year, and compare accounts receivable turnover per quarter and per year to ensure turnover does not decrease from period to period.
What is the average collection period ratio and how is it calculated?
Question: What is the average collection period ratio and how is it calculated?
Answer: The average collection period is the number of days, on average, that it takes a company to collection its credit accounts or its accounts receivables. In other words, the average collection period of accounts receivable is the average number of days required to convert receivables into cash.
The formula to calculate average collection period is the following:
Accounts Receivable/Credit Sales/365 = # Days
In order to calculate average collection period, the number for accounts receivable comes off the company's balance sheet. Sales comes off the income statement and is adjusted for credit sales. Sales is then divided by the number of days in a year to come up with average daily credit sales. The final result is a number of days, which is the average collection period.
In order to interpret the average collection period, you have to have comparative data. If you compare the average collection period to past years and it is increasing, that means your accounts receivables aren't as liquid or aren't being converted to cash as quickly. If the average collection period is decreasing, the opposite is true.
You also have to look at the company's credit policy. The average collection period should be compared with the firm's credit policy to see how well the firm is doing. If the average collection period, for example, is 45 days, but the firm's credit policy is to collect its receivables in 30 days, then the small business owner needs to fix the company's collection efforts.
Accounts Receivable Collection Period
Description:
Some people find that the accounts receivable turnover figure is easier to understand if it is expressed in terms of the average number of days that accounts receivable are outstanding. This format is particularly useful when it is compared to the standard number of days of credit granted to customers. For example, if the average collection period is sixty days and the standard days of credit is thirty, then customers are taking much too long to pay their invoices. A sign of good performance is when the average receivable collection period is only a few days longer than the standard days of credit.
Formula:
Divide annual credit sales by 365 days, and divide the result into average accounts receivable. The formula is as follows:
Average Accounts Receivable
Annual Sales/365
Cautions:
The main issue is what figure to use for annual sales. If the total sales for the year are used, this may result in a skewed measurement, since the sales associated with the current outstanding accounts receivable may be significantly higher or lower than the average level of sales represented by the annual sales figure. This problem is especially common when sales are highly seasonal. A better approach is to annualize the sales figure for the period covered by the bulk of the existing accounts receivable.
Measuring Average Collection Period
The average collection period measures the length of time it takes to convert your average sales into cash. This measurement defines the relationship between accounts receivable and your cash flow. A longer average collection period requires a higher investment in accounts receivable. A higher investment in accounts receivable means less cash is available to cover cash outflows, such as paying bills.
The average collection period is calculated by dividing your present accounts receivable balance by your average daily sales:
| Average Collection Period = | Current Accounts Receivable Balance Average Daily Sales |
The average daily sales volume is computed by dividing your annual sales amount by 360:
| Average Daily Sales = | Annual Sales 360 |
Using the annual sales amount and accounts receivable balance from the prior year is usually accurate enough for analyzing and managing your cash flow. However, if more recent information is available, such as the previous quarter's sales information, then use it instead. Be sure to compute the average daily sales correctly using the number of days actually reflected in the sales figure (e.g., 90 should be used if a quarterly sales amount is used).
David owns and operates an auto supply and repair shop. David's total annual sales amount from the previous year was $200,000. The total balance of his accounts receivable at the end of the same year was $20,000. David's average collection period is calculated as follows:
David's average daily sales volume is $556 per day:
| $200,000 $556 | = | 360 |
The average collection period is 36 days:
| $20,000 $556 | = | 36 |
For David's previous year, each dollar of sales was invested in accounts receivable for 36 days. Assuming that David's business has not changed drastically from last year, the cash inflows from sales on account will not be available for cash outflow purposes for 36 days.
| Now that you're acquainted with the average collection period, see our discussion of how you can use your average collection period to improve your cash flow. |
Using the Average Collection Period
The average collection period can be used to determine the effect of different collection periods on your business's cash flow. This is best illustrated by the following chart.
| Sales Per Day | |||||
| Average
| $200 | $300 | $400 | $500 | $600 |
| Investment in Accounts Receivable | |||||
| 30 | $ 6,000 | $ 9,000 | $12,000 | $15,000 | $18,000 |
| 40 | 8,000 | 12,000 | 16,000 | 20,000 | 24,000 |
| 50 | 10,000 | 15,000 | 20,000 | 25,000 | 30,000 |
| 60 | 12,000 | 18,000 | 24,000 | 30,000 | 36,000 |
The above chart illustrates the effect that a change in the average collection might have on the investment in accounts receivable for your business. Remember, accounts receivable represent money that cannot be used for other cash outflow purposes. For example, assume that your average sales amount per day is $300, and that your average collection period is 40 days. Now assume that you were able to reduce your average collection period from 40 days to 30 days. From the illustration above, you can see that the reduction in the average collection period reduces the investment in accounts receivable from $12,000 to $9,000. This reduction generated an additional $3,000 in your cash flow!
Accounts Receivable to Sales Ratio
The accounts receivable to sales ratio looks at your investment in accounts receivable in relation to your monthly sales amount. The accounts receivable to sales ratio helps you identify recent increases in accounts receivable. In contrast, the average collection period may only report accounts receivable information from the previous year, if that was the only information available to calculate it. Using monthly sales information, the accounts receivable to sales ratio can serve as a quick and easy way to look at recent changes in accounts receivable. The more recent information of the accounts receivable to sales ratio will quickly point out cash flow problems related to your business's accounts receivable.
The accounts receivable to sales ratio is calculated by dividing your accounts receivable balance at the end of any given month by your total sales for the month.
| Accounts receivable to sales ratio = | Accounts Receivable Sales for the Month |
Dick's accounts receivable balance at the end of the previous month was $15,000, and the total sales amount from that same month was $10,000. Dick's accounts receivable to sales ratio of 1.5 is calculated as: $15,000 / $10,000
Using the accounts receivable to sales ratio. At first glance, the accounts receivable to sales ratio might not seem like useful information. But, when you compute it each month and then look at the changes that occur as the months pass, the accounts receivable to sales ratio can signal potential problems in your cash flow. For example, an increase in your accounts receivable to sales ratio from one month to the next indicates that your investment in accounts receivable is growing more rapidly than sales. This is often one of the first signs of a cash flow problem.
My business is seasonal, how can I use the accounts receivable to sales ratio when sales fluctuate from one season to the next? A seasonal business experiences a large part of its annual sales in a particular part of the year. Comparing your accounts receivable to sales ratio to seasonal and nonseasonal months for the same year may provide you with misleading information because your business normally experiences a seasonal increase or decrease in the ratio. You can adjust your analysis by comparing your accounts receivable to sales ratio to the same month for the previous year or years.
Accounts Receivable Aging Schedule
The accounts receivable aging schedule is a listing of the customers making up your total accounts receivable balance. Most businesses prepare an accounts receivable aging schedule at the end of each month. Analyzing your accounts receivable aging schedule may help you identify potential cash flow problems.
The typical accounts receivable aging schedule consists of 6 columns:
- Column 1 lists the name of each customer with an accounts receivable balance.
- Column 2 lists the total amount due from the customers listed in Column 1.
- Column 3 is the "current column." Listed in this column are the amounts due from customers for sales made during the current month.
- Column 4 shows the unpaid amount due from customers for sales made in the previous month. These are the customers with accounts 1 to 30 days past due.
- Column 5 lists the amounts due from customers for sales made two months prior. These are customers with accounts 31 to 60 days past due.
- Column 6 lists the amount due from customers with accounts over 60 days past due.
The following is a sample accounts receivable aging schedule from Roth Office Supply:
| Accounts Receivable Aging Report
| |||||
| Customer Name | Total
| Current | 1-30
| 31-60
| Over
|
| Quick Computer Supply | $1,600 | $ 300 | $ 500 | $ 500 | $ 300 |
| Kitchens by Voels | 2,800 | 2,800 | ---- | ---- | ---- |
| Jansa's Sport Stores | 1,000 | 1,000 | ---- | ---- | ---- |
| Bradley Farms, Inc. | 1,600 | ---- | 1,600 | ---- | ---- |
| TrueBrew Unlimited | 2,000 | 1,100 | 500 | 400 | ---- |
| Enneking Enterprises | 400 | ---- | 400 | ---- | ---- |
| | 600 | 600 | ---- | ---- | ---- |
| J. Siegel, CPA | 1,200 | 1,200 | ---- | ---- | ---- |
| Total | $11,200 | $7,000 | $3,000 | $ 900 | $ 300 |
If you're using one of the many available accounting software packages for billing and accounts receivable processing, check it first to see if it prepares the aging schedule automatically. Most accounting software packages will prepare an accounts receivable aging schedule at the touch of a button!Using the Receivables Aging Schedule
The accounts receivable aging schedule is a useful tool for analyzing the makeup of your accounts receivable balance. Analyzing the schedule allows you to spot problems in accounts receivable early enough to protect your business from major cash flow problems.
The aging schedule can be used to identify the customers that are extending the time it takes to collect your accounts receivable. If the bulk of the overdue amount in receivables is attributable to one customer, then steps can be taken to see that this customer's account is collected promptly. Overdue amounts attributable to a number of customers may signal that your business needs to tighten its credit policy toward new and existing customers.
The aging schedule also identifies any recent changes in the accounts making up your total accounts receivable balance. Almost every business has to deal with customers that are slow to pay; you should expect the same for your business. However, if the makeup of your accounts receivable changes, when compared to the previous month, you should be able to spot the change instantly. Is the change the result of a change in your credit policy? Was the change in accounts receivable caused by some sort of billing problem? What effect will this change in accounts receivable have on next month's cash inflows? The accounts receivable aging schedule can help you spot these problems in accounts receivable, and provide the necessary answers early enough to protect your business from cash flow problems.
Credit Terms
Credit terms are the time limits you set for your customers' promise to pay for their merchandise or services received. When customers purchase your merchandise or services, you expect them to pay within a specific period of time (generally, 30 days). As a result of this promise, you agree to give up an immediate cash inflow until a later date. The credit terms of most businesses are either 30, 60, or 90 days. However, some businesses may have credit terms as short as 7 or 10 days. Often times a business's credit terms are dictated by an industry standard, or by its competition. For more information on the advantages and disadvantages of offering credit, see building a credit policy that works.
The credit terms for your business have a direct influence on the cash flow of your business. Longer credit terms mean your business will have to wait longer for the cash inflows from the collection of accounts receivable. In the meantime, your business may experience a cash flow shortage.
- Offering trade discounts may help speed up your cash inflows from accounts receivable, and help reduce a cash flow shortage created by extended credit terms.
- Our case study on trade discounts shows you how to decide what kind of trade discount to offer.
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