It’s important to keep your accounts receivable to a minimum, and the more you can measure the results of your efforts, the easier it will become. Here are three critical collection metrics you can use together in order to determine whether or not your credit policy is working.
Daily Sales Outstanding
In order to get a handle on your accounts receivable, you must first determine how long it typically takes to collect a past due account. Daily Sales Outstanding (DSO) is a measurement of the average number of days it takes to collect monies after a sale is made. The lower your DSO the better, as a lower number means you’re collecting the past due balances faster. If your number is high, you should reevaluate your credit policies, including who you extend credit to, and whether those collection policies need revision. If your DSO begins to climb, it might indicate that a cash crunch is approaching as more of your cash is tied up in uncollected accounts receivable. To figure your DSO, use the following calculation:
Standard DSO = Accounts receivable / Total credit sales x Number of days in measurement period
For example, if your accounts receivable totaled $20,000 and you sold $10,000 on credit in a 30-day period, you are taking an average of 60 days to collect on your invoices. Most business owners do comparisons quarterly or annually vs. prior periods.
In addition to calculating the standard DSO on your past due accounts, you should also run a Best Possible DSO, which uses only the current portion of your accounts receivable. To figure it, use this calculation:
Best Possible DSO = Current accounts receivable / Total credit sales x Number of days in measurement period
If your current accounts receivable is $3,000 and you sold $10,000 on credit in a 30-day period, your current debtors are taking an average of nine days to pay. This should serve as a benchmark to aim for in your standard DSO.
It’s important to realize that DSO should not be used as a sole metric. That’s because it can easily fluctuate and give misleading numbers, depending on your sales volume. For example, if your AR balance remains the same, but your monthly sales go up, your DSO will be lower. Conversely, if your AR balance stays the same, but you experience lower sales during a measurement period, your DSO will be higher. When combined with the following two metrics, you’ll get a clearer picture of the health of your accounts receivable.
Average Days Delinquent
Average Days Delinquent (ADD), which is also known as Delinquent DSO, measures the average time from an invoice date to the date it’s paid. It will tell you the average number of days your invoices are past due and will give you a good idea how well your collection efforts are working. To figure your ADD, use the following calculation:
ADD = Standard DSO – Best Possible DSO
If we continue to use the figures above, the ADD is 6 days.
You can use this metric to get an overall view of your accounts receivable, or narrow it down to get a view of individual customers or other classifications. Your ADD and DSO should go up and down together. If they go up, you can assume your collection efforts are working, but if they go down, you will need to determine which areas of your collections need to be adjusted. If the two metrics move in different directions, take a closer look to determine why.
Collection Effectiveness Index
In order to measure the efficiency of your collection efforts over a given period of time, you should use the Collection Effectiveness Index (CEI). It measures the percentage of your accounts receivable that are closed or paid within a time period. You should look to this metric to determine the quality of your collections, not the amount of time it takes to collect them. With it, the nearer you are to 100 percent, the better results you are achieving in your collection efforts. If it begins to drop, you should reevaluate your credit policies. Here’s how to calculate this metric:
CEI = (Beginning receivables + Monthly credit sales – Ending total receivables) / (Beginning receivables + Monthly credit sales – Ending current receivables) x 100
Although CEI sounds similar to DSO, they serve different purposes. DSO measures the amount of time it takes you to collect on an invoice after it is sent, while CEI measures your effectiveness at collecting invoices.
Staying on top of accounts receivables is one of the best things you can do to ensure your business has a healthy cash flow. Begin to use the above metrics to get a better handle on your collection efforts.