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. The average collection period, as you see at the top, is sometimes called the days sales outstanding. What it helps us understand is how long a dollar sits in accounts receivable before being collected from the customer. So, we're going to extend credit to the customer, we'll tell them they can pay us later. How long, on average, does it take us to get that money from the customers?
The average collection period is a very common efficiency ratio. It ties up our money when we credit it to the customers. When we sell something to a customer but they don't pay us yet, we don't have the money to go buy more inventory. We're going to 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 kind of bad for us. We don't want our money just sitting there in accounts receivable.
Like I said, the average collection period is related to the AR turnover ratio, which we discussed in a previous video, but let's go ahead and review it right here. Remember, the AR turnover ratio involves our net sales. If they give us information about net credit sales, we want to use credit sales because AR is related to those credit sales when we sell stuff on credit. However, many times, teachers don't get into that much detail and they just talk about net sales. So, net credit sales divided by our average AR balance. The average net AR, that's always going to be our beginning balance plus the ending balance in the account divided by 2. That’s how we calculate an average balance in an account. For AR, we take the beginning AR plus the ending AR divided by 2 to get our average AR. I mention net AR because sometimes when we talk about AR, there are contra accounts that lower the balance of AR. But usually, when you're dealing with these questions and you're dealing with ratios, they don't delve into all that and just talk about the accounts receivable balance.
The first thing we have to do is calculate that AR turnover ratio, and then we calculate our average collection period. For the average collection period, all we do is take the accounts receivable turnover and do 365AR turnover. So it’s a two-step process: first, we calculate the AR turnover ratio, and then we do 365 divided by that.
We're going to get a number here for our average collection period, and that number represents the number of days. It tells us how many days we extend credit to a customer and, on average, how long it takes them to pay us. This is what we gather from our calculation of the average collection period.
How do we analyze this? We use benchmarking, just like we do with many other ratios. We want to compare it to our competitors, we want to see how we're doing compared to the industry average. Do we take longer to collect from our customers? Is the time we take to collect from customers really short? We want to compare this to other companies. Generally, we want a lower collection period. We want to be able to collect that money quickly. We don't want to have to extend credit for many days. The lower the collection period, the better it generally implies that we're doing a good job at collecting our money, and we're being efficient since this is an efficiency ratio.
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 XYZ Company had net sales of $500,000 and the cost of goods sold (COGS) was $320,000, if the beginning balance of AR was $75,000 and the ending balance was $25,000, what is the average collection period?
Remember, when we do this, the first thing we've got to do is find our AR turnover. For the AR turnover, all we deal with is our net sales, our net credit sales if we have that information, divided by our average accounts receivable balance. Why don't we go ahead and calculate that average AR first? That's going to be the denominator here, and I don't like doing a bunch of math all in one equation. Remember, that's our beginning balance of $75,000 plus our ending balance of $25,000 divided by 2. So, $75,000 plus $25,000, that's $100,000 divided by 2, or our average AR balance is $50,000.
Now we know the denominator. The denominator of our AR turnover is $50,000. So, let's go ahead and do our AR turnover ratio. In our numerator, we're going to have our net sales of $500,000, and in our denominator, we have $50,000 which we just calculated as the average AR. So that number right there, the AR turnover, is 10. That's what we calculated here.
Now for step 2: Calculating that average collection period. All we've got to do is do 36510, which is approximately 37 days. That’s going to be our answer here. That means when we extend credit to a customer, on average, it takes them 37 days to pay us. Let's go ahead and you guys practice on the next problem.
