Average collection period

At its simplest, your company’s average collection period (also called average days receivable) is a number that tells you how long it generally takes your clients to pay you. But if you dig a little deeper, there is more to it than that.

The ratio can tell you a lot about the health of your company’s finances. By calculating it, you can determine whether it’s time to reconsider your payment terms, your credit policies or with whom you do business.

How do you calculate your average collection period?

To figure out your ratio, start by calculating your average accounts receivable value.

To do that, take the value of your receivables at the start of the period plus the value of the receivables at the end of the period and divide the sum by two. Then divide your average accounts receivable for the period by your net credit sales and multiply by the number of days in the period (365 for a year).

Your net credit sales are the revenues your business generates on credit, less any returns.

Average collection period ratio formula

1. Calculate your average accounts receivable

2. Calculate the average collection period

Average collection period calculation example

For example, suppose you run a business that has an average accounts receivable balance of $200,000 for the year, and over that same period, you recorded $2 million in net sales. Your calculation would be:

That’s not an unreasonable number, given that many businesses have a 30-day payment policy. But those extra 6.5 days could indicate that you need to take a closer look at your collection practices.

Average collection period calculator

BDC offers an average collection period calculator, which is being updated. You can manually calculate your ratio by following the above instructions.

Why calculate your average collection period?

Knowing your average collection period ratio gives you the power to manage it, says Randal Blackwood, Vice President, Financing and Advisory at BDC.

For example, if you calculate your ratio and find that it’s not favourable, you’ll know it’s time to take a closer look. You can also compare your ratio to other similar businesses and decide whether or not you need to make improvements.

Taking a long time to collect payments essentially means you have less money in the bank—which brings with it an assortment of implications.

What is a good average collection period?

A lower average collection period is generally better, says Blackwood—because a lower figure indicates a shorter payment time.

But the real answer is more nuanced. Some customers who take longer than average to pay may have other merits, such as creditworthiness.

“For example, government contracts are great because your ability to get paid is pretty much assured,” says Blackwood. “You just have to build the potential collection delays into the cost of doing business with them.”

That’s different from a situation where clients procrastinate on payments because their finances are in poor shape. That’s a risk to your business and requires your attention.

Your assessment should also consider the diversity of your client base, says Blackwood. “If your accounts receivable are heavily concentrated with one client and they run into difficulties, or are not particularly creditworthy, you might be at risk.”

What are the extra costs of having a higher average collection period?

This will differ from one company to another, but here are some of the costs you may want to examine:

• Lost interest on your capital
  Money that is not in your bank account cannot generate interest. If customers don’t pay you on time, you’re essentially lending them money.
• Interest that you pay to borrow money
  If you have large amounts of money in accounts receivable for long periods, you’re likely borrowing more than you should to run and grow your business—and paying more interest.
• Difficulty growing your business
  If too much of your cash is tied up in accounts receivable, it can hamper your plans for growth and development.
• Difficulty getting credit
  A chartered bank may deem your business to be a poor risk if your customers seem unable or unwilling to pay you on time.

For example, if you have $250,000 in accounts receivable and the payments are taking too long to arrive, then money you might like to use for other projects (such as new staff, market development or bulk inventory purchases) is tied up. You may need to use a line of credit to pursue these opportunities, which means more interest to pay.

Worse, you might use up your line of credit and be unable to keep growing your business while you wait for the payments to come in. Chartered banks may not look favourably upon your request for more funds. (BDC can offer certain businesses a working capital loan in this situation.)

The costs of prolonged borrowing while your money is tied up in accounts receivable might not be prohibitive in a stable, low-growth economy, but if interest rates are higher, you may want to think twice.

What is the cash conversion cycle?

The average collection period ratio is just one part of the larger cash conversion cycle, says Blackwood, and it’s important to understand how the two relate.

The cash conversion cycle begins as soon as your business spends money and ends when it gets paid—so it is essentially a full cycle of spending to produce a good or provide a service, including the eventual payment for it.

For example, a manufacturing company may need to invest in raw materials, overhead, equipment, labour, insurance, utilities, shipping and more just to create and distribute a product. It only gets paid after it issues an invoice and then receives payment.

“So, all of that money goes out first, and eventually—possibly months later—the company will issue an invoice,” says Blackwood. The collection period is the time between when the invoice goes out and when payment arrives.

A service company, such as a business that offers consulting, may put in weeks of effort in the way of meetings, calls, research and writing to provide a complete service, invoicing only once the project is complete. Such a company’s cash conversion cycle begins with the first phone call and ends when the client pays the final invoice.

Are average collection periods higher in certain industries?

Industries that normally collect payment as soon as a service is rendered (or sometimes even before) tend to have shorter average collection period ratios. Hotels and restaurants are good examples.

Businesses whose primary customers are large organizations—like governments and national or multinational corporations—may face longer payment times because these clients are likely to have non-negotiable payment terms that work in their favour.

That doesn’t mean you shouldn’t have large organizations as customers. But you may want to consider pricing your product or service with payment delays in mind.

Longer collection times may be most challenging or risky for manufacturing companies, which often face higher costs at the start of the cash conversion cycle, says Blackwood.

How can you improve your average collection period?

If you’ve done some calculations and have concluded that your average collection period is missing the mark, there are steps you can take to shorten it:

• Offer a discount for faster payment
  A typical discount would be 2% for paying within 10 days. Before you offer this, sit down and do some calculating, says Blackwood, because you’ll want to make sure the discount you’re offering is proportionate to the benefit of receiving the money earlier. You might find that a discount works particularly well during periods of higher interest rates.
• Impose penalties for late payments
  Because this approach is punitive, it may not work as well, but it can still be necessary at times.
• Review your credit and collection processes
  Make sure they’re airtight and that you’re only offering credit to customers who deserve it.
• Factor long collection periods into your pricing
  If you know it’s going to take 90 days to collect from certain customers, factor in an even longer period if you can.

The amount of time it takes customers to pay you may seem secondary to more exciting goals like landing new contracts, launching new products and planning for the future. But the reality is that because of their influence on your cash flow, collection periods are integral to all aspects of your business.

Next step

Discover ways to manage cash flow for your business with BDC’s free guide, Taking Control of Your Cash Flow.