DSO, DDO, and KPIs For Managing Accounts Receivable
Since accounts receivable management and working capital are critical to your business, it is important to monitor the Key Performance Indicators (KPIs) and other metrics that track your company’s credit, collections, and deduction management results. As businesses have become more complex and even global, standardized analytics have become increasingly important to track the financial health of your business. Here are the key metrics on which to focus.
1. Days Sales Outstanding (DSO) and Best Possible DSO
Standard DSO is the metric for tracking the effectiveness of Invoice Collection Management; that is how long it takes to collect payments based on the invoice date, with the goal being to reduce your DSO as close as possible to your average terms of sale (the “Best Possible DSO” of “Best DSO”).
Depending on the industry and seasonality, DSO calculations can get complicated. However, for a simple example, suppose that your AR totals $1,600,000, and Credit Sales for the last twelve months were $10,200,000, the formula would be
DSO=Total A/R / Total Credit Sales X 365, and the answer is a DSO of 57.2 days.
Best Possible DSO uses only your current (not yet past due) receivables and tells you what your best “on-time payment” turnaround could be.
Best Possible DSO = Current A/R / Total Credit Sales x 365. Using the above numbers, if your Current A/R is $800,000, your Best Possible DSO comes out to 28. In this case, you have a lot of potential for improvement between the Standard DSO of 57 Days and the Best Possible DSO of 28.
Working towards a DSO that is as close as possible to your Best Possible DSO should be the goal of your department to have a healthy cash flow and ensure your AR management is as efficient as possible. Once you start calculating the DSO and Best DSO, create monthly targets that “move towards” the Best DSO. It’s unlikely you’ll achieve perfection, so make strides to reduce the metric over a 3-6 month period.
2. Average Days Delinquent (ADD)
ADD is how many days on average payments are overdue and can be a warning sign of 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. For example, with the hypothetical company above in #1, the ADD would be 10 days on September 30. Say one year later, and the ADD is 15 days; that may mean your processes may be falling behind. Over time, measuring ADD and DSO will show you whether you are improving, static, or falling behind.
3. 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 A/R 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 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.
4. Collection Effectiveness Index (CEI)
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.
5. Deduction Days Outstanding (DDO)
By dollars. Track Customer Deduction Management results separately from invoice collection, using Deduction Days Outstdanind as the KPI. Similar to how you calculate Days Sales Outstanding (DSO) for invoice collections, add the average daily deductions amounts received during a period (say 90 days), and divide the total outstanding deductions by the average per day. For example, 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.
By the number of deductions. Another way to think about DDO is to use the number of open deduction transactions since the usual DDO metric often looks better than it really is because of the focus on large dollar items. Using this method, if deductions at month-end total 6,000 items and you receive an average of 100 deductions per day, the DDO = 60 days.
6. Deduction Effectiveness Index (DEI) New
The only reason to spend so much time and much expense (often 75% of the A/R resources) in deduction management is to find the deductions that are wrong and get the money back. Therefore, we use what we call DEI to track how well we uncover and collect erroneous deductions. Compare the percentage of deductions collected vs. total deductions by category (returns, shortages, discounts, trade promotions, etc.) month over month and YOY. Unfortunately, industry comparison data is not very useful, as companies’ processes and policies can be very different.
Since, unlike with invoices, there is no objective metric for the percentage of deductions that you should collect, the only way you will know if you are leaving profits on the table is to have deductions post-audited by an outside firm.
7. Number of Invoicing Disputes
Mistakes are costly, so you should track, by reason, 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, invoicing, or fulfillment, all of which will impact DSO as well as company profits.
8. Bad Debts to Sales Ratio
Measure bad debts as a percentage of revenues, but always look behind the number if you can 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, calculating that the extra revenues will more than offset potential losses.
9. Percentage of High-Risk Accounts
Doing business with high-risk customers is part of a 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 heading off problems down the road. You’ve collected valuable statistics, and now you need to see how you measure up. First, of course, you’ll need to look at the historical performance within your own organization, but that’s not enough. You also need to compare your performance to industry peers, and with these comparisons, you’ll be able to share insights not only within Finance but with Sales and Marketing. In today’s global, highly competitive economy, you need to be on top of your game.