The average age of accounts receivable (A/R) is calculated by dividing 365 by the annual A/R turnover ratio.
| Average Age of Receivables | = | 365 days |
| A/R Turnover Ratio |
- A lower average age of receivables indicates that a company is collecting its debts more quickly, which is generally considered a positive sign for a company’s financial health.
- A higher average age of receivables may indicate that a company is having difficulty collecting its debts, which could lead to cash flow problems.
Key takeaways
- Also known as the average collection period (ACP) or days sales outstanding (DSO), the average age of A/R indicates how long it takes a company to collect payment from its customers on credit sales.
- A lower average age of A/R generally is considered preferable because it indicates faster collection of payments.
- There’s no universal “good” average age of A/R—it depends on the industry, company size, and credit policies. However, the typical payment terms on invoices are 30 to 90 days.
Follow our step-by-step guide to learn how to calculate the average age of accounts receivable.
Step 1: Determine the Number of Days
Determine the period over which you want to measure the average age of receivables. This period then determines the number of days to use in the numerator of the above equation.
For example, if you want to measure the average age for a year, then use 365. Other common periods are 30, 90, or the actual number of days in a particular quarter or month.
Step 2: Calculate the A/R Turnover Ratio
The A/R turnover ratio is an efficiency ratio that measures how effectively a company collects its outstanding A/R from customers. In simpler terms, it tells you how much a company sells and collects its average A/R balance within a specific period, typically a year.
Here’s the formula to calculate the A/R turnover ratio, along with an explanation of the values:
| A/R Turnover | = | Net Credit Sales |
| (Beginning A/R + Ending A/R) ÷ 2 |
- Net credit sales: This represents the total revenue from credit sales during the period, after deducting any returns, allowances, or discounts. You can find this information on your company’s income statement. This period must match the number of days used in Step 1.
- Average A/R: This is the average balance of A/R over the period you’re analyzing. It’s typically calculated by adding the beginning and ending balances of A/R and dividing the sum by two—but you may use a monthly or even daily average if you prefer. You can find the A/R balance on your company’s balance sheet.
Step 3: Plug the Values Into the Formula
The remaining step is to plug the values determined in steps 2 and 3 into the average age of receivables formula. Please refer to the below example to view how it is calculated.
Example of Average Age of Accounts Receivable
Suppose ABC Company has recorded the following information over one year:
- Net credit sales: $1 million
- Beginning A/R: $100,000
- Ending A/R: $150,000
Follow these steps to determine the average age of A/R:
Step 1: Calculate the average A/R.
- Average A/R = (Beginning A/R + Ending A/R) ÷ 2
Step 2: Apply the formula for A/R Turnover:
- A/R Turnover = Net Credit Sales ÷ Average A/R
Step 3: Plug the results into the formula for average age of A/R:
- Average Age of A/R = 365 Days ÷ A/R Turnover
In this example, the A/R turnover ratio is 8. This means the company has collected and replaced its average A/R balance eight times during the year. In other words, it takes the company an average of 45.63 days (365 days divided by 8) to collect payments from customers on credit sales.
Why the Average Age of Accounts Receivable Is Important
The average age of A/R is an important financial metric for businesses because it provides valuable insights into several crucial aspects of their financial health and operational efficiency.
Here are a few examples:
- Cash flow management: A lower average age of A/R indicates that a company collects its payments from customers faster, leading to improved cash flow. This allows the company to meet its short-term financial obligations, such as payroll and supplier payments, more effectively. Conversely, a higher average age of A/R suggests potential delays in collecting payments, which can strain cash flow and lead to financial difficulties.
- Credit risk assessment: Average age of A/R helps assess the creditworthiness of a company’s customer base. A high average age of A/R might indicate a higher risk of bad debts, as customers are taking longer to settle their accounts—especially if the average age of A/R exceeds the typical payment terms given to customers on their invoices. This can prompt businesses to implement stricter credit policies, monitor high-risk customers, or adjust their collection strategies.
- Overall business performance: A healthy average age of A/R is generally considered a positive indicator of a company’s overall business performance. It suggests that the company is efficient in managing its credit sales and collecting payments from customers promptly. This improves profitability, strengthens financial stability, and enhances investor confidence.
- Comparative analysis: By comparing its average age of A/R to industry benchmarks, its own historical data, and typical payment terms given to customers, a company can gain valuable insights into its collection efficiency and identify areas for improvement. This allows for data-driven decision-making related to credit policies, collection strategies, and resource allocation.
Frequently Asked Questions (FAQs)
You can improve your company’s average age of A/R by implementing stricter credit policies like requiring minimum credit scores, setting credit limits, or offering shorter payment terms. You can also encourage faster settlement by offering discounts for early payments. It’s important to send timely invoices, reminders, and professional follow-ups for overdue payments, and streamline your billing and collection process by considering automation tools.
The average age of receivables is also known as ACP or DSO. These terms all refer to the same financial metric, which means the average time it takes a company to collect payment from customers after a sale is made on credit.
There isn’t a universal “good” average age of A/R. It depends on the industry, company size, and credit policies, but the typical payment terms on invoices are 30 to 90 days. However, a lower average age of A/R generally is considered preferable as it indicates faster collection and improved cash flow.
Understanding and analyzing the average age of A/R helps businesses manage cash flow effectively, assess credit risks associated with customers, optimize inventory management strategies, evaluate overall business performance, and benchmark against industry standards and historical trends.
Bottom Line
Learning how to calculate accounts receivable average age, also known as ACP or DSO, is valuable for businesses of all sizes. By understanding this key metric, you can gain valuable insights into your company’s cash flow, credit risk management, and overall business performance.
However, the average age of A/R is just one piece of the financial puzzle. Analyzing it alongside other relevant metrics and industry benchmarks will provide a more comprehensive picture of your company’s financial health and enable you to make informed decisions for long-term success.
