In the simplest sense of the word, every business exists to make money; and small businesses are no exception.
Firstly, what is accounts receivable?
This is basically money that a company should receive for having delivered goods or rendered services, hence the word ‘receivable’. Because this is listed against customer accounts, we have accounts receivables.
Usually, a line of credit is opened and the customer is given a specific period of time to make the payment. Not following up on your accounts receivables can lead to poor cash inflows, which might hit your operations, or you incurring losses because of having to pay interest on these payments. This is why it becomes important to track – and measure – your accounts receivables. Measuring them helps you find out which of your customers pay promptly on time. This can help you open up a larger line of credit for those customers – based on their past record of payment, you could expect them to settle larger bills on time as well – and enjoy both greater business as well as better business relationships.
These are some metrics that can help you:
Days Sales Outstanding (DSO)
The calculation works something like this:
(Accounts receivable) / (Total Credit Sales) x (Number of Days in Period)
Let us say you do business worth $500,000 a year, all of it on credit. If the accounts receivable at the end of the financial year is $125,000; then
DSO = 125,000 / 500,000 x 365
This means that it would take you 91 days to collect your accounts receivables. Now is this good or bad? If you generally allow 60 days for your customers to settle their bills; then this is a bad figure, as the figure indicates it would take you roughly three months to collect money due to you. If the DSO is less than 60 or the number of days that you allow your customers to pay up, then it is a good figure. So you should be aiming for a DSO less than the credit period.
You could do this for each of your clients and figure out which have the lowest DSOs, these are the ones that pay you the most promptly. This is the best way of running ‘credit checks’ on your customers.
Another way of measuring your company’s performance is to calculate the DSO for each month. In this case, the number of days in period would be 30 or 31; you can do the math with the accounts receivables and total credit sales during the month respectively. If it generally shows a declining trend, or the DSO is decreasing every month; then your company is on the right track to success. If the DSO is increasing with every passing month, that means you are not doing a very good job of collecting money due to you. You need to figure out what is causing this – do your customers forget (this is a highly conceivable scenario) and do they pay up only when you remind them? If yes, you might want to consider increasing the frequency of payment reminders – you could start sending out weekly reminders, or even every fortnight if you currently do so only every month.
Keep in mind that different companies may have different payment dates. Most companies settle all their debts on a specific day of the month. You need to factor this in when sending out payment reminders. If a company clears all its debts on the 15th of every month, and it regularly utilizes your products or services that you send out invoices on the 5th of every month without fail, a fortnightly payment reminder means that it reaches them only on the 19th. This would further mean that instead of getting paid within ten days, you get paid only after 40 days. Some companies do this on purpose – holding on to your cash for a month or two earns them interest. So while the credit period is a good business practice, reminding your debtors is even better for your business.
The DSO is one indicator of your company’s performance, but not the best one as it does not figure in cash sales, the other component of your business. This is to be treated as a tool to figure out areas for improvement in your business.
There is also another reason why the DSO does not accurately reflect the performance of your business – if sales suddenly increase during a particular month, and there is no corresponding change in the accounts receivables, the DSO dips. This does not in any way mean that your debtors have started paying you faster or your collection efforts have seen an improvement.
Because of this, it becomes essential to consider other metrics so that you gauge your company’s performance better.
Collection Effectiveness Index (CEI)
The calculation for CEI is like this:
(Accounts receivables at the beginning of the month + Total Credit Sales during the month – Accounts receivables at the end of the month) / (Accounts receivables at the beginning of the month + Total Credit Sales during the month – Current accounts receivables at the end of the month) x 100
At first glance, both the numerator and the denominator appear to be the same. To explain it with the help of an example, let us say you clocked $10,000 in credit sales during the month of January 2016. This is the Total Credit Sales during the month. Now let us say, you had accounts receivables of $6,000 on June 1, 2016 (this could very well be July or any other month). But you collected some of this debt and was also able to convince your clients to settle part of the $10,000 that was extended on credit; ending the month with accounts receivables of $5,000. The $6,000 is the Accounts receivables at the beginning of the month, and the $5,000 is the Accounts receivables at the end of the month.
There is one more figure you need to do the math, the Current accounts receivables at the end of the month. This refers to how much of the $6,000 you were able to collect. Let us say, you collected some $4,000 out of this. That would mean you still have to collect $2,000 more; and the $5,000 current receivables came because, you were able to get $7000 paid for $10,000 worth of goods or services in the same month itself, leaving you with only $3000 more of new debt to collect. This when added to $2000 of old debt or ‘current accounts’ leaves you with $5000 yet to be collected in total.
The Current accounts receivables at the end of the month, in this case, is how much of the original accounts receivables you started out, or ‘old debt’ you were able to collect. In this case, it would be $4,000.
CEI = (6,000 + 10,000 – 5,000) / (6,000 + 10,000 – 4,000) x 100
= 0.9166 x 100
Is this figure god or bad? Debt collection agencies (these are organizations that are called when the amount of debt becomes too high that a company finds it difficult to collect) recommend a CEI of 80% or above to remain in financially good shape.
They further suggest that you find out who the ‘good’ debtors and the ‘bad’ debtors are by applying the calculation for each company individually. You could then improve your cash flow if you were to extend more credit, in terms of the maximum amount of credit sales possible to the ‘good’ debtors. Because they pay on time, extending their periods of credit would not make any difference to your business. You also need to clamp down on the ‘bad’ debtors, both in terms of the maximum amount of credit sales possible as well as the credit period extended (this needs to be reduced).
CEI versus DSO
Ideally, they should run opposite to each other. As your CEI increases, you DSO should decline. This indicates good collection efforts and signals that your company is headed in the right direction. A decline in the CEI should theoretically be accompanied by a rise in the DSO – this would mean poor collection efforts and time for you sit up, take notice and initiate some harsh measures if you want to save your company from going under.
Debt collection agencies recommend that if possible – as in if it is in tune with your industry’s best practices – you restrict the credit period to 40 days. If your clients are doing business with you simply because you offer longer credit periods than your competitors, you also need to check if this practice is helping your business or hurting it more by way of uncollected debt. If you cannot afford to alter your company’s credit policy, find out the average DSO and try to ensure that your own company sticks to it.
If the CEI and DSO are moving upward together, or even downward at the same time; there is no need to panic – there are a few documented scenarios where this kind of situation occurs. As mentioned, these are only general metrics to help you understand the performance of your business better.
Best possible days sales outstanding
This is similar to the DSO, only it factors in current accounts receivable
If you look at the example mentioned for calculating CEI,
the DSO would be (Accounts receivable) / (Total Credit Sales) x (Number of Days in Period)
So, for June, it would be 5,000 / 10,000 x 30
DSO = 15
The Best Possible DSO would be (Current accounts receivable) / (Total Credit Sales) x (Number of Days in Period)
For the month of June 2016, it would be 4,000 /10,000 X 30
Best Possible DSO = 12
*Because the Accounts Receivables at the beginning of the month is the same, Accounts Receivables at the end of the month and Current Accounts Receivables at the end of the month are what have been considered.
It only means that while your present DSO is 15 days (this is what is observed in practice), it could theoretically be improved to 12 days; or rather you could be collecting your debt in 12 days instead of 15. You just need to figure out how to collect faster from your clients, the financial circumstances exist to facilitate this happening. In fact, if you look at it closely, you are already doing this if you are collecting old debt faster than new debt. If you can do that with old debt, you could do that with newer debt as well by following collection practices that suit your business.
Average Days Delinquent (ADD)
This is relatively simple calculation
ADD = DSO – Best Possible DSO
Considering the above case
ADD = 15 – 12
This is the same situation, but viewed from a different perspective. Every month, if your clients are repaying old debt in 12 days, but take 15 days to repay new debt, then they are said to be ‘delinquent’ by three days. The reasons for this delinquency have already been mentioned earlier, and you are free to take a fresh look at if you could bring the DSO closer to the Best Possible DSO. Your company is perfect if the DSO is the same as the Best Possible DSO, but in most cases there is a difference. Should that be the case, you should work on reducing the gap between the two.
Generally, the DSO and the ADD should move in the same direction, but if you observe them moving in opposite directions, that is only indicative of a change in credit terms or policy.
Sometimes, there is also ‘bad debt’ – that is, debt which is unlikely to be collected. This could happen because the client you were servicing has ceased to function or become liquidated. It could also happen because of a dispute in the nature or quality of the goods delivered / services rendered. In this case, good accounting requires you to hive it off under a separate section or header in your balance sheet and not include it as part of your accounts receivables.