Ratio analysis – Liquidity ratios

Ratio analysis: Liquidity ratios

The average collection period measures the average number of days it takes to collect a receivable. It is generally desirable to collect receivables as promptly as possible. The cash collected from receivables improves liquidity. Prompt collection also lessens the risk of loss from uncollectible accounts.

To compute the average collection period, the receivables turnover ratio must first be computed.

Step 1: Compute the receivables turnover ratio.

The receivables turnover ratio is computed by dividing net sales by average accounts receivable (beginning accounts receivable plus ending accounts receivable, all divided by two):

Receivables turnover ratio = Net salesAverage accounts receivable
  = $1,562,674($113,400 + $110,800) / 2
  = 13.94

The accounts receivable turnover ratio measures how many times an entity collects its receivables during the year.

Step 2: Compute the average collection period.

If 365 is divided by the receivables turnover ratio, the result is average collection period, in days.

Average collection period = 365 daysReceivables turnover ratio
  = 365 days13.94
  = 26.18364…
  = 26.2 days     (Rounded to one decimal place)