How to Calculate Average Collection Period Ratio
The average collection period ratio is a crucial financial metric that helps businesses assess their efficiency in collecting receivables. It provides insights into how quickly a company can convert its receivables into cash. By understanding this ratio, businesses can make informed decisions regarding credit policies, collections strategies, and overall financial health. In this article, we will discuss how to calculate the average collection period ratio and its significance in financial analysis.
The average collection period ratio is calculated by dividing the average accounts receivable by the net credit sales and then multiplying the result by 365 days. The formula can be expressed as follows:
Average Collection Period Ratio = (Average Accounts Receivable / Net Credit Sales) 365
To calculate the average collection period ratio, follow these steps:
1. Determine the net credit sales: Net credit sales represent the total sales made on credit during a specific period, usually a year. This figure can be found in the company’s income statement.
2. Calculate the average accounts receivable: To find the average accounts receivable, add the beginning and ending accounts receivable balances for the period and divide the sum by 2. This provides a more accurate representation of the average receivables during the period.
3. Divide the average accounts receivable by the net credit sales: Once you have the average accounts receivable and net credit sales figures, divide the former by the latter to obtain the ratio.
4. Multiply the ratio by 365: Finally, multiply the ratio by 365 to convert it into days. This will give you the average collection period in days.
For example, let’s say a company has net credit sales of $1,000,000 and average accounts receivable of $200,000. The average collection period ratio would be calculated as follows:
Average Collection Period Ratio = ($200,000 / $1,000,000) 365
Average Collection Period Ratio = 0.2 365
Average Collection Period Ratio = 73 days
This means that, on average, it takes the company 73 days to collect its receivables.
The average collection period ratio is an essential tool for financial analysis, as it helps businesses identify potential issues with their receivables management. A high ratio may indicate that the company is struggling to collect payments, which could lead to increased bad debt and a decrease in cash flow. Conversely, a low ratio may suggest that the company is too aggressive in granting credit, which could result in lost sales opportunities.
In conclusion, calculating the average collection period ratio is a straightforward process that can provide valuable insights into a company’s receivables management. By regularly monitoring this ratio, businesses can make informed decisions to improve their financial performance and maintain a healthy cash flow.
