Home Plumbing Contractor Free Plumbing and Heating Contractor Business Strategy Questionnaire 8.6 Average Collection Period Ratio Analysis Questionnaire
What is the Average Collection Period ratio and why should it be included in a business plan for a Plumbing and Heating Contractor?
The Average Collection Period Ratio is also known as the Days Receivable ratio. This is a key liquidity ratio for a small business like Central Plumbing & Heating Inc.? The average collection period ratio calculates the amount of days worth of receivables are outstanding by dividing the Daily sales by the total accounts receivables for a small business like Central Plumbing & Heating Inc. The daily sales are of course the annual sales divided by 365.
A high Average Collection Period Ratio is not good but a lower one is. The reason for this of course is very simple, a high average collection period ratio implies that the business is taking longer to collect on all its outstanding receivables whereas a low ratio indicates that the business has a fewer days to collect its receivables.
What if the Average Collection Period for a small business like Central Plumbing & Heating Inc. is very high what implications does it have for Felix Gonzalez?
Since the Average Collection Period is calculated in days, having a high ratio for a small business like Central Plumbing & Heating Inc. means that it is going to take the business a longer time to collect all its outstanding receivables. As we all know in the business world, the longer we have to wait to get paid, the lesser are the chances that we will get paid. A service once delivered loses value and hence it is very important that small business owners like Felix Gonzalez keep a sharp eye on this ratio to see just how well the business is doing with its collection.
In the event the Average Collection Period ratio for Central Plumbing & Heating Inc. remains high, it could always imply that the business will have a tough time when the going get rough and business slows down. Especially in times of a cash crunch, Felix Gonzalez may find it tough to stay afloat, pay the rent and make payroll. In situations like these small business owners often have to tap into their working capital funds or business loans just to be able to stay alive. If you are a small business owner and find that your Average Collection Period is on the higher side, you may want to make sure that you have a line of credit that you can tap into when things get rough.
Can a small business like Central Plumbing & Heating Inc. gain a competitive advantage with a lower Average Collection Period ratio?
Yes. A lower Average Collections period most certainly can give Central Plumbing & Heating Inc. an advantage over its competition. The reason for this is very simple. If Central Plumbing & Heating Inc. has a lower average collections period, it means that it has more cash handy when it needs it. It also means that it can convert its receivables in to cash relatively more quickly than the competition. Thus when tough times come and a competitor is losing market share since it cannot make its deliveries on times to the clients in a target market like Mecklenburg County, North Carolina, a business like Central Plumbing & Heating Inc. could easily come in and take some of that market share away permanently.
Small businesses are always running out of cash and that is usually why many of them fail. It is not because of insufficient planning or hard work, but it is because they don't have the ability to ride out the storms that they face in the first few years that they are in business. The Average collection period ratio reflects how well a small business like Central Plumbing & Heating Inc. can collect from its customers and is a very good barometer of the credit and collection policies in place at the business.
Does a rising Average Collections Period ratio indicate a problem ahead for a small business owner like Felix Gonzalez?
Yes. A rising average collections period ratio means that it is taking a small business owner like Felix Gonzalez longer and longer in days to collect from their customers. This could result from many things going on in the small business but at the very least it indicates that the credit and collection policy is not being adhered to the way it used to be. We find that this is very often the case when a key employee in charge of collections leaves a small business like Central Plumbing & Heating Inc. Usually the departure of this employee results in the back office losing its collection discipline and not following a good collection policy.
Many small businesses often choose a third party billing service to take care of their collections and this can often work both ways. On the one hand if you have a third party billing service collecting your receivables, you will find that they can be very reliable since they follow a set policy and collecting on outstanding receivables is their job. On the other hand, you may find that they will not be as flexible and understanding to those special customers of yours that may have a genuine need to defer their payments to you.
As a general rule, in an intensely competitive target market like Mecklenburg County, North Carolina, a small business may decide occasionally to loosen its credit collection policy to be able to book sales but usually it is not a good idea. For example in a recessionary period a local furniture retailer may decide to offer no payment for 60 days or 90 days just to get the folks to come in and buy from them. In these circumstances is it very important the business recoup the lost cash flow from higher sales and in the form of more cash flow down the line - it is one thing to move merchandise and get paid later and yet another thing to have very slow sales and have to wait a long time for your collections to come in!
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