How to calculate and analyse the receivables collection period?

Efficient cash flow management is important for any business's financial stability and growth. One crucial aspect that can impede cash flow efficiency is a lengthy receivables collection period. When customers take longer than anticipated to settle their invoices, it can strain liquidity and hinder the ability to meet financial obligations.

This article aims to delve into the concept of the receivables collection period, its calculation, interpretation, and analysis while providing insights into optimising this vital aspect of cash flow management.

Accounts receivable collection period meaning

The receivables collection period is a financial metric that measures the average number of days it takes for a business to collect payments from its customers for credit sales. It provides insights into the efficiency of a company's credit and collection processes.

By tracking this period, businesses can assess their ability to convert credit sales into cash and manage their cash flow effectively. Analysing and managing the receivables collection period is essential for maintaining a healthy financial position and optimising cash flow.

Factors affecting receivables collection period

A firm’s accounts receivables collection period is impacted by the following factors:

Company credit policy: An organisation’s collection period is largely a factor of the terms and conditions under which credit sales have been made. While a lenient credit policy encourages more sales, longer payment terms can lead to cash flow shortfalls. On the other hand, even though a stringent credit policy ensures faster collections, it may adversely impact sales volume.

Industry norms and customer preferences: Collection norms vary greatly across diverse industries, with some favouring longer payment terms. Additionally, given the focus on empowering consumers, companies must plan their communication around their customer’s preferences, which further impacts the collection period. However, omnichannel reach-out has been conducive to collection practices.

Economic conditions: Collections are impacted by the prevailing economic mood. For instance, owing to financial difficulties during economic downturns, customers may delay their payments.

Market competition: When operating in a competitive marketplace with lower pricing power, firms may be forced to offer lenient terms to attract customers and gain a competitive advantage, which can affect their cash collection cycles.

Receivables collection period formula

There are two common formulas used to calculate the receivables collection period:

1) Receivables Collection Period = (Average Accounts Receivable / Net Credit Sales) x Number of Days

2) Receivables Collection Period = 365 days / Receivable Turnover Ratio

How do you calculate the receivables collection period?

To calculate the receivables collection period as per the first formula, follow these steps:

1. Determine the average accounts receivable: Add the beginning and ending accounts receivable balances and divide the sum by two.

2. Calculate the net credit sales: Subtract returns, allowances, and discounts from the gross credit sales. The resulting value represents the net credit sales.

3. Determine the number of days: Determine the time period under consideration, such as a month or a year.

4. Plug the values into the formula: Divide the average accounts receivable by the net credit sales, then multiply the result by the number of days.

If you want to use the second formula, follow these steps:

1. Determine the receivable turnover ratio: First, calculate the net credit sales and the average accounts receivable as per the steps mentioned above. Next, calculate the receivable turnover ratio by dividing the net credit sales by the average accounts receivable.

2. Plug the values into the formula: Divide 365 days by the receivable turnover ratio.

What is an example of a receivable collection period?

Consider a small graphic design business that offers design services to clients on credit. They want to determine the average time it takes to collect payments from their clients.

Using the first receivables collection period formula, let's assume the following:

The business had an average accounts receivable balance of £6,000 during a given month, and their net credit sales amounted to £18,000. They are interested in calculating the average receivables' collection period for the month, which consists of 30 days. Plugging the values into the formula, the calculation would be as follows:

Receivables Collection Period = (£6,000 / £18,000) * 30

Receivables Collection Period = 10 days

In this example, the graphic design business has an average receivables' collection period of approximately 10 days. This means it takes around 10 days, on average, for the business to collect payments from their clients for credit sales.

What is a good receivables collection period?

A good receivables collection period is one that reflects efficient credit and collection management for a business. While the ideal collection period varies across industries, a shorter collection period generally indicates a more favourable scenario.

It implies that a business is able to collect payments from customers quickly, converting credit sales into cash promptly. This improves cash flow, reduces the risk of bad debts, and enhances liquidity.

However, what constitutes a good collection period also depends on factors like industry norms, customer payment behaviour, and the business's specific financial goals. Regular monitoring and benchmarking against industry standards can help determine and implement a good receivables' collection period tailored to the circumstances.

How to calculate your average receivables collection period ratio?

The average receivables collection period ratio is calculated by dividing the average accounts receivable by the average daily sales. The formula can be expressed as:

Average Receivables Collection Period = (Average Accounts Receivable / Average Daily Sales)

Here,

Average accounts receivable = (opening accounts receivable value + closing accounts receivable value) / 2

Average daily sales = Net credit sales / 365

Implications of Receivables Collection Period

Rationalising the receivables collection period is essential for businesses to streamline their cash flows, maintain healthy relationships with stakeholders, and ensure higher stability and business performance. Below, we outline the various implications of the collection period for an organisation.

• Cash flow and liquidity: A shorter collection period signals quick conversion of receivables into cash, accelerating cash flows. This allows businesses to maintain liquidity, service financial obligations, and pursue growth opportunities.

• Profitability and solvency: Streamlining collections minimises the risk of bad debts and associated collection costs. Efficient collections raise profitability, indicating strong solvency management and reducing the need to source external financing.

• Valuation and credit rating: The receivables collection period is an important key performance metric taken into consideration by investors, lenders, and credit rating agencies when assessing the creditworthiness and financial performance of a business. Shorter collection periods signal optimised cash flow position, resulting in higher valuations and credit ratings.

• Relationship with customers: While it is desirable for companies to collect their payments from customers early to avoid any untoward money issues, such prompt collection can strain relationships and adversely impact customer satisfaction. So, firms must balance their cash needs with collection terms to ensure customer trust is not earned by sacrificing easy liquidity.

Receivables collection period interpretation

The receivables collection period ratio interpretation requires a comprehensive understanding of the company's industry, business model, and credit policies.

Let's examine the payment collection efficiency and competitive positioning using two businesses as examples: Tasty Bites Catering and their competitor, Delicious Delights Catering, both in the catering industry.

Suppose Tasty Bites Catering has an average collection period of 30 days, while Delicious Delights Catering has an average collection period of 45 days.

Tasty Bites Catering's shorter collection period indicates more efficient cash flow management and prompt customer payments. It suggests that they have effective credit control measures in place, enabling them to access funds more quickly and allocate them toward business needs such as ingredient sourcing, equipment maintenance, or staff training.

Whereas Delicious Delights Catering's longer collection period suggests potential challenges in collecting payments from customers. It might indicate a need for improvement in credit control practices or customer payment follow-ups, such as automated payment reminders, invoice tracking, and customer payment monitoring. They could also consider reviewing their credit policies and offering incentives to encourage faster payments.

Receivables collection period analysis

Analysing the receivables collection period over time allows companies to identify trends and patterns. A consistent increase in the collection period may indicate a need to revise credit policies. In contrast, a decreasing collection period could signify improvements in credit management.

Receivables collection period increase

An increase in the receivables collection period can be a cause for concern, as it suggests potential issues in the cash flow cycle. There are several reasons why the collection period may lengthen. For instance, a company may experience a higher number of customers with delayed payment patterns, indicating potential credit risks. Additionally, changes in economic conditions or industry dynamics can impact customer payment behaviour, leading to extended collection periods.

To address an increasing collection period, companies can employ various strategies. First, they can review and strengthen their credit policies, ensuring that credit terms are clear, reasonable, and aligned with industry standards.

Furthermore, proactive and consistent communication with customers can significantly impact the collection period. Sending timely and accurate invoices, offering incentives or implementing penalties for late payment, along with regular reminders and follow-ups, can encourage prompt payment.

Companies should also consider leveraging cash collection technology to streamline their collection processes. Implementing an efficient and automated invoicing system can enhance accuracy and timeliness while reducing manual errors. Additionally, utilising online payment platforms and providing multiple payment options can facilitate faster and smoother transactions, reducing the collection period.

How to reduce receivables collection period?

Businesses must implement diverse strategies to shorten their collection period and ensure steady cash flows. Some of the steps to improve the receivable collection period are:

• Set optimal credit terms and incentives: Establish such credit terms that are attractive to customers yet do not cause collection delays. Offering incentives, such as early payment discounts, can encourage customers to pay promptly, improving cash inflows, which is particularly useful during times of high-interest rates.

• Monitor accounts receivable: To manage accounts receivable effectively, implement robust systems that utilise ageing reports to track overdue payments. Automated receivable management enables the identification of trends, potential bottlenecks, and areas for improvement.

• Deal with Overdue and Uncollectible Accounts: Establish clear processes and automate payment reminders to timely follow up with customers who have missed out on their payments. Consider renegotiating, offering alternate payment plans, or hiring collection agencies to recover outstanding balances. Write off the uncollectible as bad debts following established accounting practices.

Key takeaways

The receivables collection period is a critical financial metric that represents the average period of time it takes for the company to collect outstanding accounts receivable. Monitoring collections is essential to maintaining a positive trend line in cash flows so as to easily meet future expenses and debt obligations.

By analysing the collection period-related figures, businesses can identify areas for improvement and take corrective action to ensure a healthy financial position.