The term "collection days" is used to refer to the average amount of time it takes, in days, for an account to be paid. This is also known as the collection period or collection ratio. If a business has few collection days, it indicates that debtors pay it promptly, and that it probably has few cashflow problems because it has a steady supply of cash payments. If this value is high, however, it indicates that debtors are sluggish about repayments, and this in turn can create problems for the business.
Businesses make sales on credit to their customers as a service which is intended to attract and retain customers. It is understood that the customers would have trouble paying up front for large orders and big batches of products because they have not sold them yet. An extension of credit allows the customer to get the product and start selling it so that the proceeds can be applied to the bills.
Credit is usually offered on terms such as 30 or 90 days, meaning that customers are expected to pay within this period of time. Some debtors pay quickly, while others may take longer than the terms to make their payments; the payments may be delayed, there may be a dispute, or a business may simply be slow when it comes to handling accounts payable. As a result, it can be hard to know when money from customers will be arriving, which makes business decisions like ordering more supplies challenging.
Calculating collection days is designed to take some of the guesswork out of this by determining how long it takes, on average, for customers to pay. If the calculation reveals an average of 28 collection days, for example, the company knows that payments take an average of four weeks to arrive after invoicing.
Collection days are calculated by multiplying accounts receivable by the number of days in the year, and dividing this number by the number of credit sales. This shows how long it takes, on average, for companies to receive payments from their debtors. Outliers will, of course, skew this number; for example, companies may have large outstanding accounts which they take a long time to repay. Having a general idea of the number of collection days to expect can make daily business operations easier, however. This information can also be compared with competitors to see how promptly their creditors pay.