Part of a company’s accounting process is tracking credit extended to customers, known as accounts receivable.
An accounts receivable collection period, also known as collection days, is the average time it takes for a business to receive money from customers to whom it has extended credit. This calculation is particularly important because it affects the company’s expected cash flow. Businesses use this billing period calculation to determine if adjustments to their credit policies and terms are needed to ensure that credit is only extended to trusted customers and that payments are made in a timely manner.
Part of a company’s accounting process is tracking credit extended to customers, known as accounts receivable. The accounts receivable process can be particularly complex because it involves company policies on when to extend credit and also manages the terms of credit extension. For example, a business could extend credit to customers with a certain minimum credit score and give them 12 months to pay their bill in full. Once the line of credit is approved, the accounts receivable department manages the account, including creating an accounting record for each credit customer, collecting and recording payments made, sending payment reminders, and delay assessment.
The decision to grant a customer a period of time to pay for the goods or services they receive immediately can put significant pressure on a business. Businesses that extend credit must have enough money in the bank to pay for inventory while waiting for customers to finish paying for products they already have. To manage cash flow effectively, the business must have a reasonable expectation of when the cash will come in. You should also have some idea of how your customers pay their bills.
Calculating a company’s accounts receivable billing period allows managers to assess how long a credit account remains open. This helps them decide on a credit term that is long enough to entice customers to make a purchase, but not long enough that the business cannot maintain inventory levels or pay bills. Many businesses track the collection period of current accounts receivable and compare it to previous periods as an early indicator that changes in credit policies and terms are needed. If the billing period increases, it may mean that the business needs to tighten its credit policies or arrange additional inventory financing to offset the change in cash flow.
The basic way to calculate a company’s average accounts receivable collection period is to take the company’s outstanding accounts receivable balance at the beginning of the year and add it to the outstanding accounts receivable balance 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 that a credit account remains in receipt in the year.