Updated: May 17, 2020
A few years ago I was beginning an engagement to help a company figure our some of its internal problems and I asked the management team to forward some of their financial statements in advance of our meeting.
Early in our conversation the next day, I said, “It looks like you are having some issues collecting from customers.”
They looked at me like I was a wizard. “How did you know?” Just for fun I let them think I was a wizard for a while as we brainstormed an action plan.
There was no wizardry about it. All I did was a couple of simple division problems to create ratio using the company’s historic income statements and balance sheets. Within minutes I could see when the problem started and how bad it was. We were even later able to tie the problem back to an AR person who had mentally checked out due to personal issues. After some phone calls to customers over a million dollars arrived at the company within the next several weeks.
While there are numerous ratios that can be used to measure collections effectiveness, two of our favorites are Days Sales Outstanding (DSO) and Average Days Delinquent (ADD).
A Metric For Your Managers
Days Sales Outstanding is probably the most popular collections ratio in use and for good reason. It is the weighted average number of days a company’s receivables are in place before being collected. It offers a global view into how long it is taking a company to collect cash from its customers.
Calculating it is straightforward:
(Credit Sales)/(number of days in a time period) x average accounts receivables across the time period
It is essentially “average accounts receivable” divided by the sales a company earns in a day.
The lower the number, the faster the company is collecting from its customers.
The natural question we are usually asked is, “what is the ideal level for my DSO”? A simple answer would be that your DSO should be something similar to the terms you are extending to your customers. So, if you’ve agreed with your customers that they should pay in 30 days and your DSO is 65 (we see this very often) then you have a problem. However, to simply assume that your DSO should match your customer payment terms assumes that you’ve set customer payment terms appropriately. Terms should be no longer than what is usually extended in your industry and hopefully shorter than industry for your company. This will vary company by company, but isn’t arbitrary as it will have significant implications for your cash flow.
A Metric for Your AR Collections Team
Another metric that can be readily used to provide targets to your AR collections staff is Average Days Delinquent (ADD) To run this one you’ll need an Accounts Receivable aging report aged by due date (not invoice date).
It is simply:
Day Sales Outstanding minus Best Possible Days Outstanding
Best possible days outstanding tells us what our DSO would be if every customer paid on time. We can look to our Current AR to find this.
The calculation is:
(Average Current AR during a time period) / (Credit sales in the time period) * Days in the time period
While ADD is a great tool for measuring the effectiveness of your AR collections staff, be careful about using it to monitor the performance of those who have the ability to set terms with customers. A great way for managers to manipulate the system is to start lengthening the payment terms they have with customers and ADD will naturally start to decrease. You could end up rewarding them for reducing ADD while they are wrecking your company's cash flow.
While there are other metrics than can be used to understand collections effectiveness, these deliver a lot of insight for very little calculation effort. We recommend using them in tandem. Use DSO to monitor overall cash collection and as a measure of performance for those responsible for cash flow management. ADD, however, can be manipulated by those who are able to set customer terms, so it is better used to measure the effectiveness of those who have been tasked with collecting AR to understand how well they are doing at their job.