Accounts receivable (AR) is fundamental for managing a company's cash flow. Managing receivables is a financial process that involves invoicing, tracking, and collecting payments from your customers. It’s especially crucial for small and medium-sized businesses (SMBs) because they typically have less capital to rely on as a cushion if and when customer payments are late.
In this post, you’ll learn how to optimize accounts receivable performance with key metrics. Now let’s dive in!
Key Metrics for Measuring AR Performance
A strong AR performance is a key component of your business’ cash flow. In order to improve your AR performance, you first have to understand which areas of AR are lagging. The best way to do this is to track metrics and assess your overall AR performance. Below, we provide a list of metrics that provide key insights into the efficiency of your AR processes.
1.) Days Sales Outstanding (DSO)
Formula: Days Sales Outstanding = (Accounts Receivable/Net Credit Sales) x Number of days
- Definition: DSO is a metric that measures the average number of days it takes for a company to collect payments after making a sale.
- Calculation:To calculate your DSO, you must divide your total accounts receivable for a certain time period by the total credit sales for that same time frame. Next, multiply the result by the total number of days in the period.
- Importance: DSO provides a clear picture of how fast your company collects payments. A lower DSO indicates that customers are paying promptly, leading to better cash flow and working capital management.
2.) Best Possible DSO (BPDSO)
Formula: Best Possible DSO = (Accounts Receivable for Current Period ÷ Total Net Credit Sales) x Number of Days in Current Period.
- Definition: BPDSO is a metric that represents the lowest achievable DSO, assuming all customers pay on time. BPDSO is not typically calculated, as it represents an ideal scenario.
- Calculation: To calculate BPDSO, divide your current receivables by your total sales for the given period, then multiply that by the number of days in the period.
- Importance: BPDSO is a benchmark to understand how efficiently your company collects payments. It sets a target to strive for, showing the importance of prompt customer payments.
3.) Average Days Delinquent (ADD)
Formula: Average Days Delinquent = Days Sales Outstanding (DSO) – Best Possible Days Sales Outstanding (BPDSO)
- Definition: ADD shows the average number of days that customers are late in making payments.
- Calculation: To calculate ADD, subtract your Best Possible Days Sales Outstanding (BPDSO) from your Days Sales Outstanding (DSO).
- Importance: A lower ADD shows that customers are better at paying their invoices on time. This contributes to consistent cash flow and reduces financial disruptions.
4.) Collections Effectiveness Index (CEI)
Formula: CEI = (Total Amount Collected / Total Outstanding Receivables) x 100
- Definition: CEI measures the efficiency of your collections process. It gives another look at how well your company collects outstanding payments.
- Calculation: Calculate your CEI by dividing the total amount collected during a period by the total outstanding accounts receivable balance. This provides a percentage that represents the effectiveness of collections.
- Importance: A high CEI indicates that your collections strategies are working. It shows your ability to collect payments promptly, leading to improved cash flow.
5.) AR Turnover Ratio
Formula: AR Turnover Ratio = Net Credit Sales / Average AR Balance
- Definition: Your AR turnover ratio reveals how many times your accounts receivable is collected and replaced during a specific period.
- Calculation: To calculate your AR turnover ratio, divide your net credit sales by the average accounts receivable balance for the period.
- Importance: A high AR turnover ratio reflects good receivables management. It means that you collect payments and cycle through AR more frequently, improving your cash flow.
6.) Deduction Days Outstanding
Formula: Deduction Days Outstanding = Amount of Open Deductions / (Average Deduction Value)
- Definition: Deduction Days Outstanding tracks the average time it takes to resolve deduction issues related to payments, such as returns and disputes.
- Calculation: Calculate the total amount of open deductions by the average value of your deductions for a specific time period.
- Importance: Reducing this metric streamlines your operations, minimizes errors, and improves cash flow by resolving deduction issues more efficiently.
7.) Bad Debts to Sales Ratio
Formula: Bad Debt to Sales Ratio = Total Bad Debts / Total Sales
- Definition: Bad debts to sales ratio measures the percentage of bad debts in relation to your total sales. Any uncollectible accounts receivable are considered ‘bad debt’.
- Calculation: To calculate the ratio, divide the total bad debts by the total sales for a specific period, then multiply by 100 to show it as a percentage.
- Importance: A lower ratio indicates reduced financial risk. This helps safeguard your company's bottom line from potential losses from bad debts.
8.) Cash Conversion Cycle
Formula: Cash Conversion Cycle = DIO + DSO - DPO
- Definition: The Cash Conversion Cycle calculates the time it takes to convert resources (inventory and accounts receivable) into cash.
- Calculation: To calculate this metric, subtract the number of days of accounts payable from the sum of DSO and days of inventory.
- Importance: A shorter cash conversion cycle indicates better access to cash. This enhances liquidity and financial stability.
9.) Percentage of High-Risk Accounts
Formula: Percentage of High-Risk Accounts = (# of High-Risk Accounts / Total # of Receivables Accounts ) * 100
- Definition: This metric shows the proportion of high-risk accounts within your receivables. High-risk accounts are those with a higher likelihood of non-payment.
- Calculation: To calculate the percentage of high-risk accounts, divide the number of high-risk accounts by the total number of accounts in your receivables. Then multiply that by 100 to show it as a percentage.
- Importance: Identifying and managing high-risk accounts is vital to mitigate losses and financial setbacks. It helps you focus on accounts that require closer attention and collection efforts.
How to Improve Receivables Performance
Improving your accounts receivable involves not only tracking the right metrics but also using best practices. With the right steps, you can streamline your processes. Here, we explore some of the key practices that can boost your receivables performance:
Streamline Invoicing and Billing With Automation
- Automation Solutions Like Centime: Automated AR solutions play a huge role in simplifying your invoicing and billing. These tools automate how you generate and send invoices. This can reduce the chances of errors and ensure that you always deliver invoices to customers on time. Automation removes manual effort, freeing up your team to focus on more strategic tasks.
- Invoice Customization: With many options, you can tailor your invoices to fit your brand, add personalized messages, and include breakdowns of the products or services rendered. Customized invoices not only look professional but also give clarity to your customers, leading to quicker payments.
Clear Credit Policies and Terms
- Establishing Policies and Communication: Clear credit policies and terms are set expectations with your customers. This includes defining payment due dates, grace periods, and any penalties for late payments. It's crucial to communicate these policies with your customers, ensuring that they understand the terms of payment.
Effective Collections Strategies
- Collections Timeline Strategy: An efficient collections strategy involves setting up a clear timeline for following up with customers on outstanding invoices. It also includes recurring reminder emails or calls at specified intervals.
- How Automation Helps: Automation solutions like Centime come equipped with collections management features. They can send automated reminders and escalations, reducing the manual effort required for collections. These tools can also track customer responses and trigger follow-up actions based on customer behavior. This further enhances the efficiency of your collections process.
Forecasting and Data-Driven Decisions Based on Expected Cash Flow
- How AI-Based Tools Like Centime Can Help: AI-based tools and fintech solutions like Centime use data analytics and predictive modeling. This helps with forecasting your expected cash flow. They analyze payment patterns and customer behavior to predict when payments will come through. These insights help you make informed decisions about your business.
- Data Analytics and Predictive Modeling: Data analytics uses historical data to find trends and patterns. Predictive modeling takes this a step further by using the data to predict future outcomes. By analyzing your accounts receivable data, you can find trends in payment behavior and make better decisions to improve your cash flow.
As you work to improve your accounts receivables, keep in mind that these metrics are useful for improving cash flow and financial stability. Automation solutions like Centime can help streamline your processes and enhance efficiency. By monitoring these key metrics and using best practices, you can improve your accounts receivable performance.
Ready to enhance your receivables management? Learn how you can save money and get paid faster by automating your receivables with our eBook: Is Your AR Workflow Holding Your Cash Hostage? 7 Methods to Unlock Trapped Cash.