Overview
In this article, we will cover in detail about the account receivable collection period. This include the key definition, purpose, formula, explanation and analysis as well as its limitation. Before we jump into detail, let’s understand the overview as well as some key definition below.
As we are aware of, most businesses rely on profits to show how they have performed. However, the cash flows of a business can also give a lot of useful information about a business. If businesses only generate profits but fail to generate cash flows, they can face a lot of problems. For example, if a business cannot generate cash flows, it won’t be able to pay its suppliers on time for any purchases they make from those suppliers and end up constraining their relationship with their suppliers. Similarly, businesses also need to generate cash to pay other business expenses such as rents, utilities, repair and maintenance, etc.
The main source of cash generation for any business is through the sales it makes. Some businesses may make sales only for cash while other may allow their customers to pay later, known as credit sales. Either way, any cash generated from sales to customers, by the business, plays a vital role in the long-term stability and success of a business. Not only does it exemplify the ability of the business to generate sales but also demonstrate that the business can generate cash flows from its operations.
When businesses make sales for cash, the administration of the sales and any cash generated from these sales becomes fairly easy. However, when businesses make sales on credit, they must bear extra administrative overhead to ensure the cash is received on time. Any sales made to customers for credit must be kept in a separate account to make tracking them easier.
What is Account Receivable?
Account receivable represents all the balances receivable from the trade debtors of a business. These trade debtors of the business are its customers to whom sales are made on credit terms. Businesses choose the customers based on many requirements such as credit scores, history with the business or the importance of the customer to the business. Once these factors are determined the credit terms of sales for that customer are determined.
Businesses must decide whether they want to allow their customers to have the option to make purchases from them on credit. These decisions are based on many factors such as the industry norm, the value of credit sales to the business, the recoverability of the balances, etc. If a business chooses to only allow cash transactions, then it may lose customers that want to buy from the business on credit. However, businesses providing credits risk bad debts in recovering those debts.
If a business does choose to allow credit sales, it must ensure that there are controls in place to ensure the balances are recovered in full and on time. Businesses use many tools such as aged receivable analysis, which gives a list of all the customers of the business along with their balances sorted by the time these are expected to be recovered. If a customer does not pay within the promised time, the business can actively pursue to customer or else end up risking the recoverability of the balance. Another tool used to control account receivable balances is the account receivable collection period.
What is Account Receivable Collection Period?
The account receivable collection period is the number of days it takes the business to convert its account receivable balances to cash. In simpler terms, it denotes the time it takes for a business to recover its account receivables balances. It is also known as the days sales outstanding.
It gives a result in number of days. This can also easily be calculated in number of weeks or months if the credit periods are longer. Ideally, it should be lower or, at the very least, equal to the number of days that the business allows its customers to pay for credit sales. For businesses that rely heavily on cash sales rather than credit sales, this may even be zero or close to zero.
However, lower account receivable collection periods may also indicate aggressive credit control behaviors. For example, the credit control of the business calls their customers every day and threaten with legal action in case of failure to repay their balance within time. Businesses should ensure that it is kept at an optimal level while ensuring the satisfaction of the customers.
In addition, if the account receivable collection period of a business is significantly lower than its credit periods, it must consider whether loosening its credit control policies may result in higher sales for the company.
Purpose of Calculating Account Receivable Collection Period
The account receivable collection period of a business allows the business to evaluate its credit limits and policies. By calculating the receivable collection period, a business can determine how much time it takes for the business to recover its receivable balances. If the collection period is above the expected period, then the business will have to take steps to rectify it and ensure the chances of bad debts are reduced to a minimum.
It can also be used for decision-making purposes. Businesses base their credit limits and credit periods on their historical data such as the account receivable collection period. For example, if the business has a very high account receivable collection period, it may reduce its credit limits or periods to reduce it. Furthermore, decisions regarding whether customers should be offered early settlement discounts can be made by considering the account receivable collection period of the business.
Account receivable collection period is also an indicator of the performance of the credit control department of a business. It is the duty of the credit control department of a business to ensure the collection period of the balances is lesser or at least the same as the agreed credit period. It can also be used to make decisions about factoring account receivables or outsourcing the credit control department.
Moreover, the account receivable collection period is used in working capital management of a business. For example, the account receivable collection period of a business can be used in the calculation of its cash operating cycle. Businesses can use this information to determine the length of time it takes them from the initial purchase of raw materials to final receipt of cash from the sales of their finished goods.
Additionally, It can be used as part of the analytical procedure which is part of the audit procedures of accounts receivable to assess how the company manage its receivable.
Formula
The account receivable collection period of a business can be calculated using the formula below:
Account Receivable Collection Period = Account Receivable Balance / Total Credit Sales x 365 days
Account receivable collection period can also be calculated by using the average account receivable balance, thus, making the formula:
Account Receivable Collection Period = Average Account Receivable Balance / Total Credit Sales x 365 days
The average account receivable balance can simply be calculated using the following formula:
Average Account Receivable Balance = (Opening Account Receivable Balance + Closing Account Receivable Balance) / 2
The total credit sales are taken for the same period as the account receivable balances being considered.
Example and Analysis
A company, ABC Co., had total sales of $70 million, out of which $45 million were credit sales, during its previous year of business. Its account receivable balance at the previous year end was $6 million. ABC Co. allowed its customers a total of 30 days to repay their balances. To see how the company actually performed, the account receivable collection period must be calculated.
To calculate the account receivable collection period, the following formula must be used.
Account Receivable Collection Period = Account Receivable Balance / Total Credit Sales x 365 days
= $6 million / $45 million x 365 days
= 48.6 days or 49 days.
This means that the company took an average of 49 days to collect its account receivables. This is 19 days (49 days – 30 days) longer than the agreed period with the customers. This means that the credit control department of ABC Co. has not performed according to the set standards. ABC Co. will have to tighten its controls over the receivable balance recovery systems. ABC Co. can also consider giving customers early settlement discounts to attract earlier payments.
Similarly, XYZ Co., had total sales of $80 million, out of which $60 million were credit sales during last year. The account receivable balance at the start of last year was $3 million while at the end of last year, the balance was $4 million. XYZ Co. also allowed its customers a total of 30 days credit period. To calculate the account receivable collection period, the average account receivable balance must be calculated first.
Average Account Receivable Balance = (Opening Account Receivable Balance + Closing Account Receivable Balance) / 2
Average Account Receivable Balance = ($3 million + $4 million) / 2
= $7 million / 2
= $3.5 million
As the average account receivable balance has been calculated, the account receivable collection period can be calculated as following:
Account Receivable Collection Period = Average Account Receivable Balance / Total Credit Sales x 365 days
= $3.5 million / $60 million x 365 days
= 21.2 days or 21 days
From the account receivable collection period of XYZ Co., it can be determined that the business has done exceptionally well when it comes to managing its account receivable balances. Not only have XYZ Co. managed to recover its balances within the 30 days credit period limit but also managed to do it 9 days (30 days – 21 days) before. This shows that the credit control department of XYZ Co. have performed well. Since the result is better than expected, XYZ Co. can also consider loosening its credit control policies to attract more sales.
It is apparent from the results of both companies that XYZ Co. has performed better in collecting its account receivable balances as compared to ABC Co. However, this does not indicate a true picture. For the comparison to be truly fair, other factors must also be considered such as the nature of both the businesses and the industries they operate in.
Limitation of Account Receivable Collection Period
There are some limitations of using the account receivable collection period. As demonstrated in the example above, the account receivable collection period on its own does not mean anything. It must be compared with other information for it to be actually useful. For example, in the above example, the account receivable collection period is compared with the credit period allowed to the customers. Only then, the account receivable collection period was useful.
Likewise, the account receivable collection period can also be compared to its historical data of the same business to see how it has changed over time. This can be useful to determine the effects of any changes in the policies of the business on its ability to collect its account receivable balances. Moreover, the account receivable collection period of the business can also be checked against its competitors, other businesses in the same industry or the industry average as a whole.
When comparing between two different businesses, it is important to understand the nature of the businesses. The account receivable period is cannot be used as a comparison tool otherwise. This check isn’t necessary when comparing businesses of the same nature or businesses that are in the same industry.
The account receivable collection period may also produce non-realistic results for some types of businesses. For example, for seasonal business, the sales of the business are always within a specific period. However, the account receivable balance at the end of the period may be unusually high or low depending on when the most recent seasonal sales took place. This may result in abnormally high or low account receivable collection periods.
Conclusion
The account receivable collection period of a business is the number of days it takes a business to recover its account receivable balances from the time of the initial credit sale. It has many uses such as allowing a business to evaluate its credit policies, helping in decision-making process, being an indicator of performance of the credit control department of the business, etc. It might also have some limitations when used on its own and must used as a comparison tool to produce useful results.
