Since accounts receivable management and working capital are critical to your business, it is important to monitor the KPIs and other metrics that tell you how you perform. As business operations have become more complex and even often performed globally, metrics and analytics become increasingly important. There are dozens of possible KPIs but a few key metrics on which to focus.
Days Sales Outstanding (DSO)
DSO is the standard of baseline performance analytics and tracks how long it takes to collect payments based on invoice date. The goal is to reduce your DSO as close as possible to your average terms of sale. Annual averages can be misleading, so, in the case of a seasonal business, we might use the last 90-180 days’ revenues for the calculation, but whatever you use, be consistent.
Calculating DSO. Depending on the company, industry, and business practices, DSO calculations can get complicated. However, for a simple hypothetical, suppose that during July, August, and September, the company had $3,6000,000 in credit sales ($40,000 per day on average) and ended with $1,600,000 accounts receivable. Therefore, $1,600,000/ $40,000 = 40 Days Sales Outstanding. With N30 day credit terms, this example is not doing badly, but the Best Possible DSO is 30 days. It is the goal to get as close as possible to that.
Average Days Delinquent (ADD)
ADD is how many days on average payments are overdue and can be a warning sign to problems. If the number is high, you need to determine whether your systems, collections, and invoice processes need improvement. ADD is calculated as the DSO minus your actual average terms. Over time, measuring ADD and DSO will show you whether you are improving, static, or falling behind.
Accounts Receivable Turnover Ratio (ART)
ART is a measure of how effectively you collect your revenues as an annual broad benchmark. It is determined by taking your net credit sales and dividing it by your average accounts receivable balance. When the ratio is higher, you turn AR into cash more quickly, thus improving your working capital, cash flow, and liquidity. A high ratio can mean it is time to reconsider credit policies or collection procedures or adding collection software automation. The calculation is: ART = net credit sales / average accounts receivable. Using an example of $15,000,000 sales per year/ average AR of $2,200,000, the ART= 6.8 times.
Collection Effectiveness Index (CEI)
The ART measures how often accounts receivable turn over, but CEI measures how effective you are at collecting all outstanding money in a specific period (usually measured over one year). CEI is calculated as CEI = (beginning A/R + monthly credit sales – ending total A/R) / (all beginning receivables + monthly credit sales – ending current receivables) x 100.
Number of Invoicing Disputes
Invoicing is at the heart of accounts receivable, so you should track how many invoices have to be revised or credits issued due to billing or process errors. If the number is trending upward, it could mean that you have systemic problems in order entry or invoicing, which will, of course, impact accounts receivable collections.
Deduction Days Outstanding (DDO)
You might want to also separately age customer deductions and disputes, but the standard monthly tracking metric is DDO. Similar to how you calculate DSO, calculate the average daily deductions received during a period (say 90 days), and divide the total outstanding deductions by the average per day. If deductions at the end of a month total $1,000,000 and you receive an average of $25,000 per day, the DDO= 40 days. Another important metric would be the percentage of deductions written off and uncollectible, which might be assigned to a post-audit firm to review before giving up entirely.
Bad Debts to Sales Ratio
Measure bad debts as a percentage of revenues, but always look behind the number and compare the credit losses against sales (i) gained due to more lax credit risk policies or (ii) lost due to overly restrictive corporate credit policies. Most high-risk credit decisions are intentional and logically decided, rolling the dice and calculating that the extra revenues will more than offset any potential losses.
Percentage of High-Risk Accounts
Doing business with high-risk customers is neither good nor bad. It should be part of your business strategy. Do you have an excess of depreciating inventory? Do you need extra market penetration in a territory? Many industries are inherently ‘high-risk”, so the credit and sales managers are aligned and have to do what they can to offset the additional risk via credit instruments and, perhaps, terms or pricing.
You can’t manage what you don’t measure.
Consistent monitoring of your accounts receivable metrics and KPIs is essential to running a healthy business and becoming aware of potential problems down the road. If you have the information, you can act. Without the standard tracking metrics, you can’t tell if you have improving or declining operating performance. In today’s global, highly competitive economy, you need to be on top of your game.