Collection Ratio
The collection ratio, also known as the receivables turnover ratio or the average collection period, is a financial metric used to measure the effectiveness of a company’s credit and collection policies. It indicates how efficiently a company is collecting its accounts receivable or how quickly it is converting its credit sales into cash.
The collection ratio is calculated using the following formula:
Collection Ratio = (Net Credit Sales / Average Accounts Receivable) × Number of Days
Where:
- Net Credit Sales: These are the total sales on credit, excluding any cash sales during a specific period.
- Average Accounts Receivable: This is the average of the beginning and ending accounts receivable balances during the same period.
- Number of Days: This is the total number of days in the period being measured.
The collection ratio is usually expressed in days and represents the average number of days it takes for a company to collect payment from its customers after a sale has been made on credit terms. A lower collection ratio is generally considered favorable, as it indicates that the company is collecting payments more quickly, which can lead to improved cash flow and reduced credit risk.
It is important to analyze the collection ratio in the context of the company’s industry and historical performance. Companies should compare their collection ratio with industry benchmarks or their own historical ratios to identify potential areas for improvement in their credit and collection policies.
Example of the Collection Ratio
Let’s consider a hypothetical example to demonstrate the calculation and interpretation of the collection ratio.
Company XYZ operates in the electronics industry and has the following financial information for the year:
- Net Credit Sales: $1,200,000
- Beginning Accounts Receivable: $150,000
- Ending Accounts Receivable: $200,000
- Number of Days in the Year: 365
To calculate the collection ratio, we first need to find the average accounts receivable:
Average Accounts Receivable = (Beginning Accounts Receivable + Ending Accounts Receivable) / 2
Average Accounts Receivable = ($150,000 + $200,000) / 2
Average Accounts Receivable = $350,000 / 2
Average Accounts Receivable = $175,000
Now, we can calculate the collection ratio:
Collection Ratio = (Net Credit Sales / Average Accounts Receivable) × Number of Days
Collection Ratio = ($1,200,000 / $175,000) × 365
Collection Ratio ≈ 6.857 × 365
Collection Ratio ≈ 2502.857
The collection ratio for Company XYZ is approximately 2,502.857 days, which means that, on average, it takes the company about 2,503 days to collect its accounts receivable.
This number seems unusually high and could indicate potential issues with the company’s credit and collection policies, such as granting credit to customers with poor creditworthiness, inefficient follow-up on overdue payments, or offering overly lenient credit terms. Company XYZ should analyze its collection practices and compare its collection ratio with industry benchmarks to identify areas for improvement and optimize its cash flow.
