One of the cornerstones of managing a collections department is to calculate the average number of days it takes for customers to remit payment on an invoice. The formula is:
Average accounts receivable ÷ (Annual credit sales ÷ 365 Days)
A key part of this calculation is the average amount of accounts receivable. The method you use to calculate it can have a profound impact on the resulting calculation of the average collection period.
Here are several variations on the concept, with a critique of each one:
- Month-end balance. This is the ending receivable balance for the month. It is not an average at all, since it is comprised of a single data point, and so can yield highly variable results from month to month. Though it is the simplest option, we do not recommend it.
- Average of consecutive month-end balances for two months. Perhaps the most common calculation for average accounts receivable is to sum the ending receivable balances for the past two months and divide by two. This approach may yield a somewhat high average receivable, since many companies issue a large amount of invoices at month-end, but it at least covers the period over which receivables are currently outstanding.
- Average of consecutive month-end balances for three months. This calculation is based on the ending receivable balances in the past three months. It suffers from the same problems as using the balances at the end of the last two months, but probably also covers the full range of dates over which the typical company has receivables outstanding. Thus, this alternative tends to combine a realistic measurement time period and a relatively simple calculation.
- Average of consecutive year-end balances. This is the sum of the ending receivable balances at the end of the last two years, divided by two. These two figures are so far apart in time that it is quite unlikely that they will relate to credit sales in any given month, so the result is likely to be a skewed calculation of average collection time.
- Average of all end-of-day balances. This is an average of the amount of receivables outstanding as of the end of each business day, divided by the number of days being used to compile the average (presumably at least one month). Though the result will be the most accurate of all the options presented, it also requires the most work to compile, unless you can develop a report that automatically extracts this information from the accounting system.
In short, we suggest using an average of the consecutive month-end balances for the past three months, which minimizes calculation effort while still yielding a representative average over the likely collection period.