What is a Collection Period
The collection period, also known as the days’ sales in accounts receivable, is a crucial financial metric that businesses use to assess their financial health. It measures the average time it takes for a company to convert its accounts receivables into cash. Understanding the collection period can provide valuable insights into a company’s cash flow management and credit policies.
Understanding the Collection Period
The collection period is a reflection of a company’s efficiency in managing its receivables. A shorter collection period indicates that the company is able to quickly convert its credit sales into cash, which is beneficial for its cash flow. On the other hand, a longer collection period might suggest that the company is extending too much credit to its customers or is not efficient in collecting its receivables.
It’s important to note that the ideal collection period can vary depending on the industry and the nature of the business. For instance, businesses that operate in industries with longer credit terms might naturally have a longer collection period. Therefore, it’s essential to compare a company’s collection period with industry benchmarks or competitors to get a more accurate assessment.
Calculating the Collection Period
The collection period is calculated by dividing the total accounts receivables by the total net credit sales, and then multiplying the result by the number of days in the period. The formula is as follows:
Collection Period = (Accounts Receivables / Net Credit Sales) x Number of Days in Period
Accounts receivables refer to the money owed to the company by its customers from credit sales. Net credit sales are the total credit sales minus any returns or allowances. The number of days in the period is typically 365 days for a year, but it can also be 90 days for a quarter, depending on the period being analyzed.
Example of Collection Period Calculation
Let’s say a company has total accounts receivables of $500,000 and net credit sales of $2,000,000 for the year. Using the formula, the collection period would be:
Collection Period = ($500,000 / $2,000,000) x 365 = 91.25 days
This means that on average, it takes the company 91.25 days to collect its receivables.
Utilizing Accounts Receivable Factoring
Invoice factoring, also known as accounts receivable factoring, is a type of financing that converts outstanding invoices into immediate cash for your small business. The other party involved in this transaction is known as a factor or factoring company.
Factoring virtually eliminates a business’s accounts receivables collection period. The factoring company purchases the invoices from a business at a discount and advances the invoice funds to the business. This way, the business can get immediate cash, which can be used to finance various operational needs.
How Does Invoice Factoring Work?
Invoice factoring involves a straightforward process. A business sells its outstanding invoices to a factoring company. The factoring company then provides the business with an advance, typically around 80% of the invoice value.
Once the factoring company collects the full amount from the customer, it will then pay the remaining balance to the business, minus a factoring fee. This fee is typically a percentage of the invoice value and is agreed upon at the start of the transaction.
Benefits of Invoice Factoring
Invoice factoring provides immediate cash flow. This can be particularly beneficial for businesses that have long collection periods or those that have clients who are slow to pay.
The Bottom Line
With invoice factoring, businesses can get immediate cash instead of waiting for clients to pay their invoices. This can significantly improve a business’s cash flow by eliminating the collection period of accounts receivables.