The average collection period ratio is also known as the days sales outstanding ratio.
The average collection period is the number of days, on average, that it takes a company to collect its credit accounts or its accounts receivables. In other words, this financial ratio is the average number of days required to convert receivables into cash.
The formula to calculate average collection period is the following:
Accounts Receivable/Credit Sales/365 = # Days
In order to calculate average collection period, the number for accounts receivable comes from the company's balance sheet. Sales come from the income statement and are adjusted for credit sales. Sales are then divided by the number of days in a year to come up with average daily credit sales. The final result is a number of days, which is the number of days, on average, it takes a company's credit customers to pay their accounts.
In order to interpret the average collection period ratio, you have to have comparative data. If you compare the average collection period to past years of company data and it is increasing, that means your accounts receivables aren't as liquid or aren't being converted to cash as quickly as in the past. If the ratio is decreasing, then customers are not only paying their credit accounts on time but faster than they have in the past.
You also have to look at the company's credit policy. The average collection period should be compared with the firm's credit policy to see how well the firm is doing. If the average collection period, for example, is 45 days, but the firm's credit policy is to collect its receivables in 30 days, then the small business owner needs to take a look at the firm's credit policy.