Average collection period for outstanding payments
Many companies, especially those dealing with mainly business customers allows their customers a credit period for making payment. The customers can purchase goods and services on credit, and pay for these items later. However, it is possible that the customers may not to pay the company on time, adversely affecting the cash flow of the company. If the company does not have enough cash flow, it may not be able to pay its expenses on time, and it may have to take loans or make other arrangements for funds. Hence it is necessary to ensure that the company is able to collect the payment due to its customers on time.
Definition
The Average Collection Period, abbreviated as ACP is the average time the company takes to collect dues outstanding from its customers. It is measured for a specific period usually a year. For this, the average outstanding amount for the period is considered, using the outstanding amount at the beginning of the period and the end of the period and compared to the total sales for the period. The ACP may also be calculated for a shorter period of time. It is an important parameter for determining the cash flow and payment collection practices of the business.
Formula
The formula for calculating the ACP is linked to the receivables turnover and sales of the business.
Receivables turnover = Sales revenue/ Average accounts receivables
ACP for a period of one year = 365 / Receivables turnover
The above formula can be rewritten as ACP = 365 X Average receivable/Sales revenues
The second part of the formula indicates the fraction of sales for which the payment has not been received when compared to total sales. The fraction is then multiplied by the number of days in the year, 365 to indicate the average ACP for the business
Explanation
Most businesses allow their larger customers a credit period for making payment after the purchase, typically thirty days for most businesses, though it may be ninety days or more in some cases. The company will plan its cash flow and payment of expenses accordingly. Ideally, most customers will pay up their bills before the credit period expires. Yet in some cases, the customers may not pay the amount due because of their own financial problems or other reasons. In this case, the company should follow up with the customers and ensure that they make the payment at the earliest.
The ACP is an indicator of the business whether their customers are making the payment for credit purchases on time. For example, if the credit period is thirty days, and the ACP calculated is for twenty-five days, it indicates that most of the payment is made before the due date. However, if the ACP for the business is forty days, it indicates that customers are not making payment on time, and the business should improve its collection policies, follow up with customers to ensure that they make the payment on time. For businesses with mainly seasonal sales, the ACP may be very low or very high depending on when the peak sales are taking place. If the sales are at the beginning of the period, ACP will below, and if sales are towards the end of the period, ACP could be very high.
Importance
The ACP may not be very important when considered alone, yet comparing the changes in the ACP over a period of time, can help the business note trends and take decisions accordingly. The business can also compare its ACP with the ACP for other businesses in the same sector to compare its performance and payment terms. Investors can compare the ACP of different companies as a performance metric. While a low ACP is desirable, if the ACP is far lower than other companies in the sector, it could mean that the company is extremely strict in its collection policies. Hence some customers could move to other companies offering credit for a longer period.
Industry receivables
All industry sectors do not rely on receivables to the same extent, yet for some sectors, the ACP is important. For the banking sector, the banks have a large amounts due from customers since they give loans and mortgages. They should ensure that their customers pay the amount due on time, else their revenues will reduce. Similarly, in the construction sector, companies have many expenses like labor, material supplies and other services. These companies do not have a regular cash flow, hence they should bill their customers on time, and collect payments, so they can pay their expenses on time.
