Did Average Collection Period Ratio Gives View in Cash Management Cycle

Avg. Collection period = 365 ÷ Receivables Turnover

Average collection period formulakeeps an eye on the number of days a company takes to turn in its receivablesinto cash. To calculate avg. collection period one can simply divide the numberof days in a term by receivable turnover ratio.

As you can see the formula presented earlier on this page contains 365 in the numerator, as there are 365 days in a year. However, in the case where you want to calculate the debtors turnover ratio for a short period for instance for 3 months, you can use 90 days instead. Similarly, the denominator must also be adjusted for that specific period which we use in the numerator.

Average Collection Period

Let’s take an example tocalculate the average collection period for a company having a receivableturnover ratio of 9 for the fiscal year 2016. By using this data we can getavg. collection period as;

Avg.collection period = 365 ÷ 9

=40.55 days

However on the other side, if wetweak things slightly. Now the receivable turnover ratio is 4.78 for the periodof 7 months. Now calculating the average collection period for such case willbe;

Avg.collection period = 213 ÷ 4.78

=44.54 days

Any company will have a lowerreceivables turnover ratio where a larger period is required to convertreceivables into cash. OR company is selling all of its products on a longercredit plan rather than a cash preference system.

How the average collection period is helpful for analysts

The average collection period may be helpful in a number ofways to understand the financial position of a company in the foreseeablefuture. However, usually, one standalone figure does not help often becauseonly one analysis will not hold much value but it is the best metric suited forcomparison over time.

For an analyst, it is the best to approach to calculate the averagecollection period over time and then find any anomalies or trends for both inauspiciousand auspicious events. Moreover, one can also use any other company within the sameindustry as a benchmark to compare for a better view. The debt coverageratio is another metric which can be used along with the average collectionperiod for a clear and in-depth view-ability into company’s stability.

How average collection period formula build-up

Basically, the formula for the average collection period isbuilt-up by using the accounts receivable turnover formula. The formulafor receivable turnover is here;

Receivables turnover = Sales revenue ÷ avg. accounts receivable

By looking on receivable turnover now we can see that if wetry to rewrite the formula, we will get;

Avg. collection period = 365 × [average accounts receivable ÷ sales revenue]

Now the second portion in the formula calculates the part oftotal sales which is on credit and payment will be received any time in future.Now we convert this % of sales into days by multiplying it with 365 todetermine average collection period.

However, some external factors can influence the resultscompletely, as seasonal sales can affect the average collection period andoverall analysis also in the long run. On the other side if a company isdealing with multiple products and offering different credit period fordifferent products this may also be a point to consider for precisecalculations.