The average collection period indicates the days it takes a company to convert its receivables into cash. The company’s credit terms will have a significant impact on the average collection period: the better the credit terms, the higher the average collection period.
An increase in the average collection period could indicate an increased risk of the company’s customers not being able to pay for their purchases. A possible result is that the company will have to hold greater levels of current assets as a reserve for potential losses or bad debt expense.
Most large companies (nonretail) do not handle many cash sales. Therefore, when looking at financial statements, it can be assumed that total sales do not include any cash sales. However, in smaller companies and in retail businesses, cash sales can be a significant part of the total sales.
Formula for Average collection period
Reliance Industries has accounts receivable in the amount of Rs.28,030 and credit sales in the amount of Rs.210,000. In this example, credit sales and total sales are identical. This gives an average collection period of 48.72 days, which means that it takes a little over one and a half months for the company to convert credit sales into cash.