Definition, Explanation and Use:
The trade receivables’ collection period ratio represents the time lag between a credit sale and receiving payment from the customer. As trade receivables relate to credit sales so the credit sales figure should be used to calculate the ratio. However the amount of credit sale is usually not separately available in the income statement so in that case total sales could be used.
Closing trade receivables are normally used in the calculation as it is usually not possible to derive an average trade receivables figure on consistent basis. This ratio is normally calculated in the number of days which a business takes to collect cash from the trade receivables. This ratio highlights both the collection efforts put by the business and the quality of trade receivables.
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Analysis and Interpretation:
Short collection period is usually preferred. As the receivables’ collection period provides an insight into the credit terms offered to the credit customers. Early collection from trade receivables is not only good from liquidity point of view but this may also reduce the level of bad debts and administration costs on collecting receivables. However a tight credit policy to reduce collection period may reduce the level of sales.
A lengthy collection period might suggest that the business:
- Adopts a more liberal credit policy than its competitors to attract more customers; or
- Has weak credit control procedure; or
- Is a new business; or
- Is selling low quality product or service; or
- is selling goods to less credit-worthy customers.
The selection of an effective credit control policy involves weighting its probable benefits against its expected costs. However as mentioned earlier, early collection period is usually preferred.