Introduction to Corporate Finance

18: Cash Conversion, Inventory and Receivables Management

Average Collection Period

The average collection period (ACP), also known as days’ sales outstanding (DSO), is the second component

of the cash conversion cycle. As noted in Chapter 2, it represents the average number of days that credit

sales are outstanding. The average collection period has two components: (1) the time from sale until the

customer places the payment in the mail; and (2) the time to receive, process and collect the payment

once it has been mailed by the customer. Equation 18.11 gives the formula for determining the average

collection period:

Eq. 18.11 Averagecollectionperiod

Accountsreceivable

Averagesalesper day

=

If we assume that the receipt, processing and collection time is constant, then the average collection

period tells the company how many days (on average) it takes customers to pay their accounts. In

applying this formula, analysts must be consistent in their use of the sales period and must adjust for

known seasonal fluctuations.

example

GS Schofield Enterprises has an accounts receivable
balance of $1.2 million. Sales during the past 90 days
were $3.6 million for an average daily sales figure
of $40,000. Dividing $1.2 million by $40,000 yields
Schofield’s average collection period of 30 days.

However, a diligent analyst at Schofield notices

that sales have been increasing recently, with average

sales over the last 30 days of $45,000 per day. Using

this figure in the denominator of Equation 18.11

results in an average collection period of 26.7 days.

The average collection period allows the company to determine whether there is a general problem

with its accounts receivable. However, the ACP can also send misleading signals when daily sales

fluctuate. In the preceding example, suppose that Schofield’s credit terms are net 25. Using the most

recent month to calculate average daily sales results in an average collection period of 26.7 days, which

is right on target, given Schofield’s credit terms. However, using average daily sales over the past three

months yields the longer, 30-day collection period. Therefore, when using this ratio to assess the

performance of the collections department, analysts have to be aware of the impact of sales fluctuations

on their calculations.

If a company believes that it has a collections problem, a first step in analysing the problem is to age

the accounts receivable. By doing so, the company can determine if the problem exists in its accounts

receivable in general or rather is attributable to a few specific accounts or to a given time period.

Ageing of Accounts Receivable

The ageing of accounts receivable requires the company to break down its accounts receivable into groups

based on the time of origin. Ageing results in a schedule indicating the portions of the total accounts

receivable balance that have been outstanding for specified periods of time. The breakdown is typically

made on a month-by-month basis, going back three or four months.

The purpose of ageing accounts receivable is to allow the company to pinpoint problems. For example,

if a company with terms of net 30 has an average collection period (minus receipt, processing and

collection time) of 50 days, then it will want to age its accounts receivable. If the majority of accounts

are two months old, then the company has a general problem and should review its accounts receivable

operations. If the ageing shows that the company collects most accounts in about 35 days, and that

What are some of the methods

companies use to monitor

their outstanding accounts

receivable?

thinking cap

question

ageing of accounts

receivable

A schedule that indicates the

portions of the total accounts

receivable balance that have

been outstanding for specified

periods of time