Why is it important for a company to have an average collection period?
In every business it is very important to have an average collection period. This time period refers to the time span a company or organization has to balance everything related to finances.
This system of balance includes all accounts receivable in the form of payments made to the company by clients. Companies set up an "average" collection period to analyze receipts, how many accounts have paid, how they have paid, and how the company will turn the assets into cash, especially in cases where clients have paid with credit.
The formula goes:
- Days = Total amount of days in period
- AR = Average amount of accounts receivables
- Credit Sales = Total amount of net credit sales during period
What a company or small business wants is to make the collection period as short as possible so that the process of checking tabs, matching to the payments, and converting credit into cash is quicker. The shorter this collection period is, the faster the company gets to see revenue. In cases where large corporations extend credit to certain clients, it could be simply because the corporation has had a long history with the client and is assured that the money will be paid. Moreover, these types of business relationships often occur in large and wealthy corporations where a few late checks or payments are not as important as they are in small businesses.
After the average collection period, the small business can re-arrange itself and pay its employees, collect profits, and invest more into the business.