Key Metrics to Help Spot Trends and Performance Issues
The aged accounts receivable (AR) report is valuable for managing customer credit accounts. You can see how much money is overdue by looking at the totals in the various aging columns. However, an aged AR report only represents a snapshot of accounts receivable at a specific date, usually at month-end. And if you have many customers, the aged AR report will contain a lot of detail. Consequently, the report does not allow you to see the larger picture or understand trends.
The best way to monitor accounts receivable is to distill the information into KPIs (key performance indicators). KPIs will provide you with an at-a-glance indication of the state of the accounts receivable and the effectiveness of collections. AR KPIs can also be used to compare customers, types of customers and the performance of individual employees responsible for collecting outstanding invoices. Here are 10 KPIs that will help you understand and manage your accounts receivable.
1. Standard Days Sales Outstanding (DSO)
The DSO KPI indicates how long, on average, it takes customers to pay their invoices. The metric is also an indication of the effectiveness of collection methods. The formula for DSO is Total A/R ÷ Total Credit Sales X 365. The higher the number, the longer sales invoices remain unpaid. The closer that DSO is to your standard credit terms, the better. However, it should be noted that anomalies in the underlying figures can affect KPIs. For example, an unusually high-value sales invoice unpaid in the year’s final month would increase DSO.
Related: 9 Quick Tips to Get Your Invoices Paid Consistently and On Time
2. Best Possible DSO
Comparing DSO to standard credit terms may not be possible. Some customers may have been granted different credit terms from the standard. And you would be fortunate indeed if all customers paid on or before the due date. Consequently, a more realistic way to assess the standard DSO is to compare it to the best possible DSO, the calculation for which is Current A/R ÷ Total Credit Sales x 365. The crucial difference between the two DSO KPIs is that only current invoices are included in the best possible DSO KPI, not overdue ones.
3. Average Days Delinquent (ADD)
The average days delinquent KPI tells you the average number of days customer accounts are overdue. This metric is calculated by deducting the best possible DSO from the standard DSO (standard DSO minus best possible DSO). ADD is an excellent indicator of the effectiveness of your collection efforts.
4. Accounts Receivable Turnover (ART)
The accounts receivable turnover ratio indicates how fast AR accounts turn into cash. The formula for annual ART is net credit sales ÷ average accounts receivable. So, if sales are $120,000 per year, the average AR total is $10,000, then the ART ratio is 12, meaning AR accounts are cleared monthly. However, if the average total AR balance were $30,000, the ART ratio would be 4, indicating that customers take an average of three months to pay their invoices.
Related: 8 Significant Risks to Small Business Cash Flow
5. Collections Effectiveness Index (CEI)
The collections effectiveness index provides further insight into the efficiency of the collection process. This metric tells you the percentage of overdue invoices collected. The CEI formula is (opening accounts receivable + monthly credit invoices – closing accounts receivable) ÷ (opening accounts receivable + monthly credit invoices – closing current account receivables). A CEI of 80% or more is considered good in most industries. A CEI of 50% or less would indicate there might be an issue with collections.
6. Number of Disputed Invoices
It is advisable to track and monitor the occurrence of disputed sales invoices. An upward trend in the number of disputed invoices could point to problems in the invoicing function or elsewhere in the organization. There might be inaccuracies in invoices, or there could be issues with the product or service quality. Consequently, it will help isolate problems by recording a reason code alongside disputed invoices.
Related: How to Collect Overdue Sales Invoices Without Losing Your Customer
7. Number of Deductions
Customers may sometimes only part-pay a sales invoice, in which case a balance will remain outstanding against the invoice. Deductions will occur for the same reasons as a disputed invoice. Both could also be a stalling tactic to gain more time to pay. If short-paid invoices are common, it would be advisable to monitor the reasons for deductions. It will also be helpful to track how long it takes to resolve part-paid invoices.
8. Cost of Collections
Collecting delinquent AR accounts can be costly. The costs include salaries, postage, and legal fees. Consequently, it is advisable to monitor the cost of collections, especially when there are many customer accounts to be managed. Knowing how much it costs to collect a delinquent account will help you decide if outsourcing your accounts receivable would be cost-effective. It will also be helpful when determining if a small balance is worth pursuing.
Related: How Much Are Your Accounts Receivable Costing You?
9. Percentage of High-Risk Accounts
It may sometimes be necessary to do business with high-risk customers. However, over-reliance on such customers could lead to high exposure to bad debt. High-risk customers might be those with low credit scores. Start-ups will also pose a greater risk than established companies. Monitoring the percentage of high-risk accounts will help manage accounts receivable and keep risk to an acceptable level. Identifying customers in this category will also be helpful when determining appropriate collection tactics.
10. Bad Debt to Sales Ratio
The bad debt to sales ratio is crucial for planning and forecasting. Knowing this number will allow you to make a sufficient bad debt provision. The metric will also indicate the effectiveness of your credit checking procedures and collection methods. Of course, you will want to keep the bad debt ratio low. However, zero bad debts are not always a good thing; it could mean that you are too risk-averse.
The Bottom Line
Robust AR management is crucial for any business that offers customers credit. But it can be challenging to see the wood for the trees when there are many AR accounts. Monitoring the above KPIs will allow you to see the big picture. You can then drill down to the underlying detail to identify the root cause of adverse trends.
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