What it means
Every business that invoices rather than takes cash at the till has a gap between making a sale and being paid. The collection ratio puts a number on that gap by comparing the receivables balance to the value of credit sales over a period.
A ratio of 45 days means the average invoice sits unpaid for six and a half weeks. That number matters because unpaid invoices are cash the business has earned but cannot spend.
A company growing quickly with a long collection ratio can be profitable on paper and still run out of money, because it funds each new sale before the previous one has been paid. This is one of the most common causes of failure in otherwise healthy small businesses.
The calculation is straightforward: average receivables divided by credit sales, multiplied by the number of days in the period. Some analysts express the same relationship as a turnover figure instead, dividing credit sales by average receivables to get the number of times the receivables balance is collected in a year.
The two views are simply reciprocals of each other. Interpretation depends entirely on the terms offered.
A ratio of 45 days is excellent if the company sells on 60 day terms and poor if it sells on 14 day terms, so the meaningful comparison is against your own stated terms and against last year, not against a generic benchmark. A useful rule of thumb is that the ratio should not exceed the stated terms by more than about a third.
The measure has two well-known weaknesses. It uses averages, so a handful of very large or very late accounts can hide behind an acceptable-looking headline, and it moves with the timing of sales within the period rather than with collections effort alone.
Reviewing it alongside an ageing schedule and the collection effectiveness index gives a much fuller picture.
In practice
Real-world examples.
Example
A staffing agency pays contractors weekly but collects from clients in 52 days on average. The mismatch forces it to run an invoice finance facility costing around $70,000 a year. Cutting the ratio to 40 days would let the agency reduce the facility by roughly a fifth.
Example
A specialist chemicals manufacturer reports a collection ratio of 38 days against 45 day terms and is quietly proud of it. A review of the ageing schedule reveals that two customers pay in 10 days while the rest average 60, so the headline number is masking a real problem. The team starts reporting the ratio by customer segment instead.
Example
A construction subcontractor's ratio jumps from 47 to 72 days after it wins work with a large main contractor that pays on completion of milestones. The finance director builds the longer cycle into the cash forecast and negotiates a milestone schedule with more frequent stages. Profit was never the issue; timing was.
Think of it
“Collection ratio shows what percentage of your bills actually get paid-your collection success rate.
Formula
Calculation
Collection ratio in days = (Average accounts receivable / Net credit sales) x 365
Receivables turnover = Net credit sales / Average accounts receivable
A commercial printing business has net credit sales of $3,650,000 for the year. Its receivables were $420,000 at the start and $480,000 at the end, so average receivables are ($420,000 + $480,000) / 2 = $450,000.
Collection ratio = ($450,000 / $3,650,000) x 365 = 0.1233 x 365 = 45 days.
Expressed the other way, receivables turnover = $3,650,000 / $450,000 = 8.1 times a year, and 365 / 8.1 gives the same 45 days.
Since the company sells on 30 day terms, it is being paid 15 days late on average. Pulling the ratio back to 35 days would release roughly $100,000 of cash, because $3,650,000 / 365 = $10,000 of sales a day, and ten days of sales is $100,000.Case study
Seen in the real world.
The following is a fictional example written to illustrate the concept. Tallow Bay Signage, an invented maker of shopfront displays, doubled revenue to $6 million in two years and still could not pay its own suppliers on time. Its collection ratio had drifted from 41 days to 68 days without anyone tracking it, so roughly $1.1 million was locked up in unpaid invoices.
The owners made three changes: they took a 30% deposit on every order above $10,000, moved invoicing from the end of the month to the day of installation, and introduced a weekly call list for anything over 40 days old. None of these were sophisticated, but together they attacked the two components of the ratio at once.
Within six months the collection ratio was back to 44 days, releasing about $390,000 of cash and removing the need for a planned overdraft increase. In this illustrative story the business did not need more sales, it needed the sales it already had to convert into money faster.
Watch out
Common mistakes.
- Using total sales rather than credit sales, which flatters the ratio in any business with a meaningful proportion of cash or card takings.
- Using the closing receivables balance instead of the average, which distorts the figure badly in a seasonal business.
- Judging the ratio against an industry benchmark rather than against your own payment terms, when the terms are what define good or bad performance.
Questions
People also ask.
Is a very low collection ratio always good?
Not necessarily; an unusually low number can mean the business is offering heavy early payment discounts or turning away customers who need normal credit terms.
Is this the same as days sales outstanding?
Yes, the two names describe the same calculation, though days sales outstanding is the more common phrasing in management reporting.
How quickly can the ratio be improved?
Invoicing promptly and chasing systematically usually shows results within one or two collection cycles, so a business on 30 day terms can often see movement inside a quarter.
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