Most businesses run on a cycle of purchasing, inventorying, and then selling their products or services. When it comes to purchasing and selling, it is done through a process of credit.
This simply means that the seller gets paid after some time, and the buyer pays after some time. To meet financial obligations, sellers need to calculate the average time to ensure they have enough money to pay their creditors.
The average collection period is a financial term that helps measure the amount of time taken for customers to pay back the credit given.
What is Average Collection Period
Accounts receivable (AR) are payments that companies receive from their customers, and the average collection period is the amount of time it usually takes for them to get those payments.
In other words, this metric reflects how long a company typically waits before receiving money owed to them by clients or customers.
It is important to keep track of how long it takes a company on average to collect its money. This is because the company needs to make sure it will have enough cash soon to pay its bills and maintain a healthy cash flow.
How Average Collection Period Works
To understand how the average collection period works, it’s important to learn what accounts receivable are.
Accounts receivable refers to money owed by customers or clients; when a business extends credit to its customers and allows them to purchase items or services without paying upfront, the amount they owe is referred to as “accounts receivable”.
It’s basically invoicing the customer, and then the customer pays back the amount over a certain period.
Most businesses use this system to increase their customer base and make sure that customers can buy with confidence without having to pay upfront.
However, it’s important to keep track of when the customer is expected to pay and how long it usually takes for them to pay back. This is where the average collection period comes in handy, as it provides a good measure of how long it typically takes for customers to pay their debts.
By monitoring this metric, businesses can identify if there are any changes in their customers’ payment habits, which could have an impact on their overall financial performance.
How to Calculate Average Collection Period
The calculation for the average collection period is fairly straightforward. It is calculated by taking the average accounts receivable balance and dividing it by total credit sales for a given period (usually one month).
For the formula of the average collection period, it is expressed as follows:
Average Collection Period = (Accounts Receivable / Credit Sales) x Days in the Month
To calculate this metric accurately, businesses should keep a close eye on all accounts receivable and credit sales.
By doing so, they can determine their average collection period quickly and easily. This, in turn, allows them to better plan ahead and make sure they have enough money to pay their creditors on time.
Conclusion
The average collection period is a useful metric for businesses to measure the amount of time it takes customers to pay back the credit given. By understanding how this works and calculating it accurately, companies can ensure they can maintain healthy cash flow and meet their financial obligations.
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