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Average Collection Period: Formula & Analysis

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  • 0:00 Average Collection Period
  • 0:51 Collection In Real Life
  • 1:50 Accounts Receivable Turnover
  • 3:00 Credit Policies
  • 4:14 Payments
  • 4:57 Lesson Summary
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Lesson Transcript
Instructor: Tammy Galloway

Tammy teaches business courses at the post-secondary and secondary level and has a master's of business administration in finance.

In this lesson, you'll learn the purpose of calculating the average collection period and the two-step process. We'll also discuss which financial statements are needed to find the data and the importance of comparing the average collection period to the credit policy.

Average Collection Period

The average collection period is a measurement of the average number of days that it takes a business to collect payments from sales that were made on credit. Businesses of many kinds allow customers to take possession of merchandise right away and then pay later, typically within 30 days. These types of payments are considered accounts receivable because a business is waiting to receive these payments on an account. Accounts receivable are an asset, or something a business owns or is owed.

As you might expect, businesses keep a close eye on these types of accounts, because if they don't receive the money that they're owed when it is due, they won't be able to pay their own bills. In this lesson, we're going to explore how a company tracks its accounts receivable and what equations it uses to find an average collection period by looking at a real-world example.

Collection in Real Life

Jenny Jacks is a high-end clothing store that sells men's and women's clothing, shoes, jewelry, and accessories. Because the store's items are so expensive, it allows customers to make purchases using credit. When an item is sold on credit, the accounting manager enters the amount of the item into the books as an account receivable.

This is great for customers who want their purchases right away, but what happens if they don't pay their bills on time? The accounting manager at Jenny Jacks is going to be watching for this and will run monthly reports to assess whether payments are being made on time. He's going to calculate the average collection period and find out how many days it is taking to collect payments from customers.

The average collection period is calculated using a two-step process:

Step 1: Find accounts receivables turnover by dividing the credit sales by the accounts receivable

Step 2: Find average collection period by dividing the accounts receivables turnover by 365

Accounts Receivable Turnover

As we said earlier, accounts receivable are the monies owed to a company, or in Jenny Jacks's case, from customers who've been allowed to use credit. In order to calculate the average collection period, you must calculate the accounts receivables turnover first. The accounts receivable turnover shows how many times customers pay during a year.

The accounting manager of Jenny Jacks calculates the accounts receivable turnover by taking all the credit sales and dividing them by the accounts receivable.

Credit Sales / Accounts Receivable = Accounts Receivable Turnover

These figures come from two different financial statements. The credit sales are reported on the revenue section of the income statement and the accounts receivable are reported in the asset section of the balance sheet. Looking at these two reports, the accounting manager at Jenny Jacks finds that the credit sales were $2,500,000 and the accounts receivable were $250,000. So he applies the equation of credit sales/accounts receivable:

$2,500,000 / $250,000 = 10

and finds that customers of Jenny Jacks paid, on average, ten times per year.

Credit Policies

The next step in the process is to look at Jenny Jacks credit policy. When a company creates a credit policy, it sets the terms of extending credit to its customers. Credit policies normally specify when customers need to pay their bills, what the interest charges and fees are if payments are late, and whether there are any benefits for paying early. Credit policies don't address how often their customers will pay per year, though.

So the accounting manager meets with the credit manager, who tells him that the credit agreement states payments should be made every 30 days. He then can calculate the average collection period:

Number of days in a year (365) / Accounts Receivable Turnover = Average Collection Period

which works out here to be:

365 / 10 = 36.5

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