Uncollected AR is one of the reasons why many businesses experience cash crunches. During these crunches, spending power becomes either severely limited or nonexistent. Every business relies on solid cash flow in order to thrive. But to maintain a strong cash flow, a company must maintain strong accounts receivable management.
One essential aspect of good AR management is keeping track of the relevant metrics, particularly the accounts receivable collection period. This essential metric keeps track of how long your AR stays uncollected, letting you know if the average period remains healthy for your business. If you’re wondering what this ratio is, why it’s necessary, and how you can calculate yours, then this article is for you.
What is an Accounts Receivable Collection Period?
Many businesses rely on credit sales to engage and retain customers. These businesses expect to receive payment on a predetermined date. In the meantime, the unpaid credit sale gets recorded as accounts receivable. The accounts receivable collection period is the number of days it takes, on average, for a business to receive payments on outstanding AR. It shows how long until customers repay their uncollected invoices starting from the date of the credit sale.
You can get an idea of how your business can use this metric when determining future cash flow. This metric lets you figure out if you’ll remain liquid, with enough incoming cash in the future to pay for everyday needs and more.
A low accounts receivable collection period value means you’re collecting payments faster. A higher value indicates that your collection efficiency might need a little more work.
Either way, it gives a direct reflection of the overall effectiveness of your business’s AR management.
The Importance of Calculating Your AR Collection Period
As a business that sells on credit, you’d want to make sure that you get paid as quickly as possible. After all, a sale doesn’t constitute an actual cash transaction. So even if you’re raking in revenue, you still need to get paid so your sales can become cash inflow. Quick customer payments mean more cash will be available for your business.
The lower your average AR collection period, the better off your business will be in terms of its lifeblood, which is cash on hand or the bank. One of the KPIs of your cash management team when meeting liquidity goals is to lower this number. Simply put, having an ideal AR collection period results in your business having a greater capacity to grow.
How to Calculate Your Accounts Receivable Collection Period
Your business’s AR collection period is calculated by dividing your accounts receivable turnover ratio for a given period, typically a year, by the number of days in that same period.
Companies often assess their AR collection period annually. The “days” in the equation refer to the number of days in the period being calculated, which, as mentioned, is typically one year. The “receivables turnover” at the bottom is calculated using another data set.
Calculating Your Accounts Receivable Turnover Ratio
To come up with your average AR collection period over a specific timeframe, you’ll need to calculate the receivables turnover.
The accounts receivable turnover formula is as follows:
Computing your accounts receivable turnover ratio requires gathering your net credit sales and the average accounts receivable balance during the period. You then need to get the ratio of your net credit sales over the average accounts receivable balance. Let’s look at these two variables in more detail.
Your company’s net credit sales are the total revenue it made on credit less sales returns and allowances over the period. All sales made on credit are non-cash transactions your customers must pay later, accruing as accounts receivable. Sales returns and allowances are reductions in prices resulting from issues with the sales transactions, such as when a company underdelivers on their goods.
Getting your company’s average accounts receivable balance is a matter of looking at your balance sheet’s AR entry for each month’s end and getting the average of the last 12 months (if you’re going after an annual period).
After getting your net credit sales and average AR balance, it’s time to calculate your receivables turnover. Simply use the accounts receivable turnover formula shown above, filling out the details as necessary.
What Your Accounts Receivable Turnover Ratio Tells You
This ratio lets you know your collection team’s efficiency in staying on top of collectibles. Since it shows the rate at which customers pay off their outstanding invoices, it can be an essential KPI for your overall cash management .
For example, if your company had a net credit sales amounting to $1.5M and an average AR balance of $150,000 during the prior year. Using the receivables turnover formula: $1,500,000/$150,000, we get an accounts receivable turnover ratio of 10. This ratio indicates that your company’s AR turned over at a rate of 10 during the prior year.
A high AR turnover ratio is viewed as optimal, particularly if a company constantly meets its sales targets and doesn’t have restrictive AR policies that negatively impact revenue. Business scope and industry can also impact receivable turnover. It’s always best to compare yours to businesses in the same industry to gauge the effectiveness of your AR management.
Calculating Your Accounts Receivable Collection Period
Now that you’ve gathered all of the necessary variables, you can finally calculate your AR collection period. To recap, here’s the AR collection period formula:
The “days” refers to the number of days in your chosen period. The “receivables turnover,” which we have discussed earlier, is the rate at which you collect AR. You get this ratio by dividing your net credit sales by your average AR balance over your chosen period.
Upon calculation, we arrive at the “period,” which is simply the Accounts Receivable Collection period, or the amount of time your customers repay you on average.
Using the example above, with a net credit sale of $1.5M and an average AR balance of $150,000, you’ll have an accounts receivable turnover ratio Period = 365/10 of 10. Since this receivables turnover was for a prior year, you’ll have to substitute 365 for “days.”
If you’re computing for six months, substitute the day figure with 180, or 90 if you’re calculating for three-simple enough.
Period = 36.5 days
In this case, it takes an average of 36.5 days for invoices to be fulfilled, from date of sale to date of actual cash payment.
What’s the Difference Between AR Receivable Collection Period and DSO?
DSO, or days sales outstanding and accounts receivable collection period, analyzes the same metric, which is how long it takes, on average, for customers to settle their unpaid invoices . However, the two use different formulas to arrive at their consecutive results.
DSO is calculated by dividing the total number of AR during a period by net credit sales during that same period. You then need to multiply the result by the number of days you’re trying to measure.
Let’s say your company has an accounts receivable balance of $150,000 while making a $1.5M net credit sales in the prior fiscal year. Using the DSO formula, we can calculate the days sales outstanding in the number of days.
DSO = ($150,000 / $1,500,000) * 365
DSO = 36.5 days
In this example, your company takes 36.5 days to collect cash from customers. Quite similar to our example above on AR collection period.
Utilizing Your AR Collection Period
Companies compare their AR collection period on their own policies regarding customer payment terms. For example, having a collection period of 36.5 days on top of a 45-day company payment policy shows you’re efficient at collecting what customers owe.
On the other hand, a 36.5 day average collection period under a 15-day payment policy means that you might not be collecting as efficiently as you should.
You can also use this metric in comparison to industry standards. Find out the specific period that’s acceptable for your particular industry. Also, comparing your AR collection period to other firms in your industry, particularly those who you know performs well, can help you gauge how well your own cash management is doing.
If you want, you can plot consecutive AR collection periods to form trend lines, like on a month-over-month basis. Trends allow you to spot problems by watching for spikes and drops in your AR collection period trend.
Take Advantage of AR and Cash Management Software
Want to reduce your average AR collection period? Why not utilize technology and automation? Peakflo lets you put your AR on auto-pilot , resulting in faster payments and boosted cash flow. And no, you don’t have to be tech-savvy to use our seamless AR management platform.
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Originally published at https://peakflo.co on January 30, 2022.
