Sometimes referred to as the average collection period, a collection ratio has to do with the outstanding Accounts Receivable of a given company. The ratio is an average of the amount of time that is usually required for payment on the invoices issued for a given calendar period to be paid in full by the customers. The time frame for factoring the collection ratio begins with the date of issue on the invoices, and concludes once the outstanding invoices have either all been paid or the few unpaid invoices have been written off the receivables account.
Collection ratios are a helpful calculation for many businesses. By understanding the average amount of time it takes for customers to pay outstanding receivables, the company can evaluate the current procedure for creating and issuing invoices. For example, the company may be issuing invoices once a month, and thus missing the payment cycle that is common to most of the customer base.
Since the invoices are received after the cut off date for inclusion in the current payment cycle, the invoices are not paid until the next cycle. This can add as much as thirty extra days to the collection ratio. If the collection ratio demonstrates a trend where a large portion of the clientele are paying closer to sixty days rather than thirty days, the company may choose to begin issuing invoices a few days earlier. This change will make it possible for the outstanding invoices to reach customers before the end of the current cycle.
The collection ratio can also provide warnings that an undesirable change is taking place in the receipt of payments for outstanding receivables. This is true when the collection ratio appears to be lengthening in comparison to previous periods. Generally, this phenomenon can be traced to specific clients who may be experiencing financial difficulties or who have recently made changes in their internal Accounts Payable procedures. Once the origin of the increased collection ratio has been discovered, the company can take steps to correct the trend.
