The average collection period measures the length of time it takes to convert your average sales into cash. This measurement defines the relationship between accounts receivable and your cash flow. A longer average collection period requires a higher investment in accounts receivable. A higher investment in accounts receivable means less cash is available to cover cash outflows, such as paying bills.

The average collection period is calculated by dividing your present accounts receivable balance by your average daily sales:

Average Collection Period = Current Accounts Receivable Balance Average Daily Sales

The average daily sales volume is computed by dividing your annual sales amount by 360:

Average Daily Sales = Annual Sales 360

Using the annual sales amount and accounts receivable balance from the prior year is usually accurate enough for analyzing and managing your cash flow. However, if more recent information is available, such as the previous quarter's sales information, then use it instead. Be sure to compute the average daily sales correctly using the number of days actually reflected in the sales figure (e.g., 90 should be used if a quarterly sales amount is used).

David owns and operates an auto supply and repair shop. David's total annual sales amount from the previous year was $200,000. The total balance of his accounts receivable at the end of the same year was $20,000. David's average collection period is calculated as follows: David's average daily sales volume is $556 per day:

$200,000 $566 = 360

The average collection period is 36 days:

$20,000 $566 = 36

For David's previous year, each dollar of sales was invested in accounts receivable for 36 days. Assuming that David's business has not changed drastically from last year, the cash inflows from sales on account will not be available for cash outflow purposes for 36 days.

Now that you're acquainted with the average collection period, see our discussion of how you can use your average collection period to improve your cash flow.