Introduction

The average collection period, also known as the days’ sales outstanding (DSO), is a financial metric that helps businesses evaluate their accounts receivable management. This metric measures the average number of days it takes for a company to collect payments from its customers after a sale is made. A shorter average collection period indicates that a company collects its accounts receivable more efficiently and has lower credit risk. On the other hand, a longer average collection period indicates that a company may have difficulties collecting its receivables which could affect its cash flow and operational efficiency.

In this article, we’ll walk you through the steps to calculate the average collection period so that you can better understand your company’s financial performance.

1.Gather Necessary Financial Data

To calculate the average collection period, you’ll need two key pieces of information from your company’s financial statements:

– Net credit sales: These are your total sales made on credit minus any returns or allowances.

– Average accounts receivable: This is the average balance of your accounts receivable during a specific time period.

You can find these figures on your income statement and balance sheet. If your financial statements don’t provide net credit sales, you can use total sales as a proxy.

2.Calculate Daily Credit Sales

Divide your net credit sales by the number of days in the period for which you’re measuring the average collection period (usually 365 days for an annual calculation):

Daily Credit Sales = Net Credit Sales / Number of Days in Period

For example, if your net credit sales for the year were $500,000, you would calculate daily credit sales as follows:

Daily Credit Sales = $500,000 / 365 = $1,369.86

3.Calculate Average Collection Period

Finally, divide your average accounts receivable by daily credit sales to get your average collection period:

Average Collection Period = Average Accounts Receivable / Daily Credit Sales

Continuing with our example, if your average accounts receivable for the year were $150,000, you would calculate the average collection period as follows:

Average Collection Period = $150,000 / $1,369.86 = 109.6 days

Interpreting the Results

In this example, the average collection period of 109.6 days indicates that it takes approximately 110 days on average for the company to collect its accounts receivable. You can compare this figure to industry benchmarks or your company’s historical data to evaluate your accounts receivable management’s effectiveness.

A shorter average collection period suggests that your company collects cash efficiently, freeing up capital for investments or reducing debt. A longer average collection period reveals potential issues with your company’s credit policies or collection procedures and may indicate a need to tighten credit terms or improve collection efforts.

Conclusion

Calculating the average collection period is a simple yet powerful way to assess your company’s financial health and collections efficiency. By regularly monitoring this metric, you can identify areas for improvement and make informed decisions about credit and collections policies to better manage cash flow and reduce credit risk.