Sometimes referred to as a collection ratio, the average collection period has to do with the relationship between Accounts Receivable and the time frame in which those outstanding payments are received. Essentially, this period is a calculation of the average period it takes for outstanding invoices to be paid in full after issuance.
One of the immediate advantages of understanding average collection periods is that the information allows the company to anticipate cash flow generated by services rendered. Rather than hoping that all customers pay promptly within thirty days of the issuance of the invoice, the average collection period calculation replaces the expectation with the reality of how quickly the customer base as a whole is remitting payments. This information makes it much easier for the company to schedule payments for services rendered to their own vendor partners, as well as arrange to keep funds on hand to handle day to day operations, meet payrolls, and other important aspects of doing business.
Another valuable usage of calculating the average collection period is that the company can spot unfavorable trends early on. If the period for the same time last year was 34 days and it is now up to 42 days, the situation bears investigation. The reasons may be immediately identifiable, such as the acquisition of a high volume customer over the last year that was granted sixty-day terms of payment. On the other hand, there may be longtime clients whose payment patterns have changed. This may involve factors on the part of the customer or in the invoices are forwarded to the customer.
As an example, if the customer notified the company several months ago of a change in mailing address, but the change was never recorded, then the invoice will have to be forwarded by the postal service. This could add several days to the process alone. Second, a client may have changed their Payables procedures, and now cut checks to their vendors every other week, instead of weekly. Looking into where the changes have taken place and why may uncover issues that can be addressed and resolved easily, thus restoring a more advantageous collection period figure.
Understanding that there is some ebb and flow in all collection periods, allowances should be made when calculating an average collection period figure. The incidence of holidays, seasonal activity such as vacations, and natural factors such as weather may all impact the speed with which payments are received from customers. Keeping those factors in mind, but also investigating to determine if there are recurring issues that are impact the average collection period, will help ensure a business is receiving payments for services rendered in as timely a manner as possible.
