Calculate the Average Collection Ratio
For large transactions, most businesses offer their customers the opportunity to purchase goods or services through credit. The Average Collection Period is the average amount of time that it takes for the company to receive payments on the receivables it is owed. Sometimes referred to as the “collection ratio”, the average collection period measures the reality of how quickly the customers are remitting payments.
The Importance of the Average Collection Period to Investors
The average collection period is a valuable measure for investors, enabling them to spot unfavorable trends early on. If, for example, the average collection period for a given timeframe proves to be longer than it was for the same timeframe a year earlier, the company has become less efficient in its collections efforts. This can be a red flag.
Low v. High Average Collection Period
Demonstrating a low average collection period as compared to industry competitors is seen as favorable, indicating that the company is doing a good job of converting receivables into cash. A high collection period means the company has a high cost in extending credit to customers.
Understanding is average collection period makes it easier for a company to plan for payments it owes to its suppliers and other vendors. It also enables the company to make plans to keep funds available to handle its daily operations, meet payroll requirements, and other costs of doing business.
Tracking Collection Efficiency
It is worth noting that, as a company grows, its average collection period will often increase as it may struggle with efficiencies in staying on top of the money it is owed. It is, therefore, a use measure for a company to track so it may continuously evaluate its current procedures for creating, issuing, and pursuing invoices.
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The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax advisor.
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