Ratios: Average Collection Period (Days Sales Outstanding)
14. Financial Statement Analysis
Ratios: Average Collection Period (Days Sales Outstanding) - Video Tutorials & Practice Problems
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Ratios: Average Collection Period (Days Sales Outstanding)
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So let's discuss another ratio related to the accounts receivable turnover ratio. And it's called the average collection period. Let's check it out. So the average collection period. Well as you see at the top sometimes it's called the days sales outstanding. Okay. What it helps us understand is how long a dollar sits in accounts receivable before being collected from the customer. Right? So we're gonna extend credit to the customer. We're gonna say you can pay us later. Well how long on average does it take us to get that money from the customers? Okay so when we think about the average collection period it's a very common efficiency ratio right? We want to see how efficient we are at loaning out or being given credit terms to our customer. Right? So remember that extending credit to the customer. It ties up our money right? When we when we sell something to the customer but they don't pay us yet. Well we can't just go ahead. We don't have the money to go buy more inventory. Right? We're gonna have to have other money available to replenish our inventory to make more sales. So the longer the money sits tied up in accounts receivable. Well that's that's kind of bad for us. Right? We don't want to just have our money just sitting there and accounts receivable. So the average collection period like I said it's it's related to the er turnover ratio which we discussed in a previous video. But let's go ahead and review it real quick right here. So the er turnover ratio remember that the A. R turnover ratio We're gonna have our net sales and if they give us information about net credit sales well we want to use credit sales because remember A. R. Is related to those credit sales when we sell stuff on credit. But a lot of the times teachers don't get into that much detail and they just talk about net sales. Ok so net credit sales divided by our average A. Our balance right average and A. R. And that's always going to be our beginning. Every time we do an average right every time we do an average balance of an account it's always going to be the beginning balance plus the ending balance in the account divided by two. That's always how we calculate an average balance in an account and that's what we see here right for a. Are we did the beginning A. R. Plus the ending A. Are divided by two. And that was our average A. R. And I say net they are because sometimes when we talk about A. R. There's going to be the contra accounts that lower the balance of A. R. But usually when you deal with these questions and you're dealing with ratios they don't get into all that and they just talk about the accounts receivable. Cool. So first thing we gotta do is calculate that A. R. Turnover ratio and then we calculate our average collection period. Remember that's what we're here for average collection period. Well all we do is we take that accounts receivable turnover. And we're gonna do 3 65 divided by the accounts receivable turnover. Cool. So it's a two step process first we calculate the our turn Turnover ratio and then we do the 365 divided by that. Cool. So how do we analyze this? We're gonna get a number here and the number that we get out of our average collection period? It's a number of days. How many days does a dollar sit in a are? Right, just like we said how many days we extend credit to a customer and on average how long does it take them to pay us for that? Cool. So we're gonna get a number of days when we calculate this? And how do we compare this? How do we compare, How do we know if our collection period is good or bad? What we're gonna use benchmarking? Just like we do with a lot of other ratios, benchmarking. We want to compare it to our competitors. We want to compare it to the industry average. How are we doing? Does it take us a lot longer to collect from our customers? Is it really short the time that we collect from the customers? Right. We want to compare it to the other companies. So what does this mean? Do you think that we want a high collection period? Do we want it to be a high number of days or a low number of days? Well in general we want a lower collection period, right? We want to be able to collect that money quickly. We don't want to have to extend credit for a long time. Hundreds of days extending credit. We want to be able to lend extend credit to the customer and they pay us as quickly as possible. Cool. So the lower the collection period that generally implies that we're doing a good job at collecting our money and we're being efficient. Right? This is an efficiency ratio. So let's go ahead and jump into an example and then you guys can practice one on your own. Let's do this one together. If X. Y. Z. Company X. Y. Z. Company had net sales of 500,000 and costs of 320,000. If the beginning balance of A. R. Was 75,000 and the ending balance was 25,000. What is the average collection period? Alright. So remember when we do this, the first thing we gotta do is find our A. R. Turnover, right? It's a two step process. So the first step a our turnover. And remember a our turnover. What about pogs? We don't need that number. Right? This is extraneous information. A. R. Turnover. All we deal with is our net sales are net credit sales. If we have that information divided by our average uh average accounts receivable balance. So a our turnover. Well why don't we go ahead and calculate the average A. our first right because that's gonna be the denominator here. And I don't like doing a bunch of math all in one equation. So let's get that average a. Our first remember that's our beginning balance of 75,000 Plus our ending balance of 25,000 divided by two right? Beginning plus ending divided by 2 75,000 plus 25,000. That's 100,000 divided by two. Or average A our balance is 50,000. Right? So now we know the denominator right? The denominator of our A. R. Turnover is 50,000. So let's go ahead and do our A. R. Turnover ratio in our numerator. Well we're gonna have our net sales of 500,000. And in our denominator we have 50,000 that we just calculated as the average A. R. So that number right there. Let me do it in a different color. A. Our turnover underline this a our turnover is 10. Right? So 10 is our our turnover ratio but that's not what they're asking us for here. Right? We want our average collection period. So that was step one was getting the A. R. Turnover. Step two is calculating that average collection period, average V. Collection period. And all we gotta do is do 365 divided by that A. R. Turnover 3 65 divided by the 10. We just calculated and noticed they didn't do any decimals. They rounded it off here so that's approximately 37 days. Right? That's gonna be our answer here. So that means when we extend credit to a customer, on average, it takes them 37 days to pay us. Cool, let's go ahead and you guys practice on the next problem.
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Problem
Problem
ABC Company had $200,000 in Net Sales and Gross Profit of $80,000. If AR had a balance of $16,000, what are the days' sales outstanding?
