Definition of Average Collection Period
Average collection period (ACP) also known as ‘ratio of days to sales outstanding’ is the average number of days the company takes to collect its payment after it makes a credit sale. The financial ratio gives an indication of the firm’s liquidity by providing an average number of days required to convert receivables into cash.
ACP is calculated using the average balance receivable divided by the average of credit sales a company makes on a per day basis.
Formula of ACP
or,
There is also another formula to calculate the Average Collection Period
Where,
Accounts Receivable Turnover Ratio = Credit Sales for a Year / Average Amount of Accounts Receivable in that Year
Examples of Average Collection Period (With Excel Template)
Let’s take an example to understand the calculation of the Average Collection Period in a better manner.
Example #1
A company XYZ dealing in home décor has accounts receivable of $10,000 at the start of the year and $40,000 at the end of the year. The credit sale made for this amount is $250,000.
Solution:
Average Balance Receivable is calculated as
- Average Balance Receivable = ($10,000 + $40,000) / 2
- Average Balance Receivable = $25,000
Average Collection Period is calculated using the formula given below
Average Collection Period = Days in Period * Average Accounts Receivables / Average Credit Sales Per Day
- ACP = (365 * $25,000) / $250,000
- ACP = 36.5 days
This indicates that on average the company receives the amount after 36.5 days.
Example #2
Consider the balance sheet and Income statement for Apple Inc.
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Source Link: Apple Inc. Balance Sheet
Solution:
Average Net Receivables for Apple Inc.is calculated as
- Average Net Receivables = ($23,186 + $17,874) / 2
- Average Net Receivables = $20,530
Since the Company has not provided the amount of credit sales, we can consider the net sales to calculate the days of the collection period.
Average Collection Period is calculated using the formula given below
Average Collection Period = Days in Period * Average Accounts Receivables / Average Credit Sales Per Day
- ACP = (365 * $20,530) / $59,531
- ACP = 125.87 days
Advantages of the Average Collection Period
Advantages of the ACP are as follows:
- The company can make a decision on how to pay its short-term debt by lowering its ACP.
- The company can keep track of its ability to collect the amount receivables.
- The company can decide on the means to collect the balance amount by knowing their ACP.
- By comparing the ACP of previous years, a company can predict whether its ability to collect receivables is increasing i.e. days taken to collect receivables are decreasing. If the ACP is increasing it indicates that the company is losing its liquidity.
Increasing the Average Collection Period
An increase in the ACP would indicate any of the following conditions:
- Management has decided to loosen the credit conditions to customers in order to boost sales or a certain category of customers are given longer credit window- This could be true in case a small business house is trying to sell to a bigger business whose credit quality is good and the small business believes that it will not default.
- Liquidity issues in the economy could cause customers to delay payments.
- Either the collections department of the company has reduced its effort or there is an overall staff shortage. In both cases, the collection for the period is less thereby increasing the number of receivables outstanding.
Decreasing the Average Collection Period
ACP can be decreased using the following practices:
- Management may decrease the length of credit or tweak its credit policy so to reduce credit sales. This may lower the risk for the company.
- By offering discounts on early receivables than agreed and putting penalties on late receivables.
- Increase communication levels with customers and run credit checks on them.
- Increasing collection efforts by employing more employees and using technology. Incentivizing employees towards reducing the ACP.
Commonly, it is considered that the Average Collection Period aimed by a company is one-third times lower than the expressed credit terms.
Important Points to Note on Average Collection Period
- If a company is selling its products/ services seasonally, calculating the ACP for the whole year would not be just and the formula for ACP should be adjusted likewise.
- A higher ACP indicates that the company needs to take steps to collect receivables, otherwise there is a risk of receivables turning into bad debt.
Conclusion
Average Collection Period can be defined as the time taken by a company to collect the amount from the goods and services sold on credit. Tracking ACP helps the company to keep a check on its finances and make a credit policy. The ACP is also indicative of the Company’s short-term liquidity.
Recommended Articles
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