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An accounts receivable collection period, also known as days in receivable, is the average amount of time it takes a business to collect money from customers to whom it has extended credit. This calculation is particularly important because it effects a company's anticipated cash flow. Businesses use the calculation of this collection period to determine whether adjustments need to be made to its credit policies and terms to ensure credit is extended only to reliable customers and payments are made in a timely fashion.
Part of a business' accounting process is keeping track of credit it has extended to customers, known as accounts receivable. The accounts receivable process can be particularly complex because it involves the company's policies about when to extend credit and also manages the terms of the credit extension. For example, a company might allow the extension of credit to customers with a certain minimum credit score and give them 12 months to pay their bill in full. Once the credit line is approved, the accounts receivable department manages the account, including setting up an accounting record for each credit customer, collecting and recording payments made, sending payment reminders and assessing late fees.
The decision to allow a customer a length of time to pay for goods or services that he receives immediately can put a significant strain on a business. Companies that extend credit must have enough money in the bank to pay for inventory while waiting for customers to finishing paying for products that they already have in their possession. To effectively manage cash flow, a company must have a reasonable expectation of when money will come in the door. It must also have some insight into the way its customers pay their bills.
Calculating a company's accounts receivable collection period allows managers to evaluate the amount of time a credit account remains open. It helps them decide on a credit extension term that is long enough to entice customers to make a purchase, while not being so long that the company ends up unable to maintain inventory levels or pay bills. Many companies keep track of the current accounts receivable collection period and compare it to previous periods as an early indicator that changes are needed to credit policies and terms. If the collection period is increasing, it may mean that the company should tighten its credit policies or arrange for additional inventory financing to compensate for the change in cash flow.
The basic way to calculate a company's average accounts receivable collection period is to take the outstanding balance of the company's receivables at the beginning of the year and add it to the outstanding balance of the receivables at the end of the year. Divide the amount by two, and divide the result by the company's net credit sales. Multiply the result by 365, the number of days in a year. The solution is the average number of days a credit account remains in receivables for the year.
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