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Measuring your efforts

In an earlier post I talked about calculating your DSO.  The most well know way to benchmark your A/R is by using the Days Sales Outstanding (DSO) calculation.  It’s a common, well understood indicator that is widely used. The fact that it is so common makes it easy to find DSO numbers for an industry or individual company, both locally and across the world. This enables you to benchmark against those DSO numbers and ask questions about your receivables. You can answer such questions as: How am I doing with my customer base compared to company X in my same industry? Are my terms in line with others in my industry? etc.. However, many credit professionals will tell you that they dislike DSO as an internal benchmarking metric and I will give you an example why.

The DSO problem

DSO is not the most accurate way to indicate if you are collecting effectively. DSO can be misleading as it has a key weaknesses, that is it fluctuates with revenue.  Changes in sales inversely affect the DSO. If your overdue receivables balance stays the same an increase in sales for the month will lower your DSO. If you suddenly have a dip in sales your DSO will shoot up. DSO, while valuable for benchmarking, cannot alone give you a clear picture of the performance of your A/R. Three other measures of collections performance include ADD and CEI. These help complete the A/R picture and let you know if you are truly being effective in your efforts to get paid faster.

Collection Effectiveness Index

The Collection Effectiveness Index (CEI) is becoming increasing popular in the credit and collections world. CEI was developed by Dr. Venkat Srinivasan and the Credit Research Foundation (Link).  With the Credit Research Foundation collecting statistics, it is also possible to do the same industry benchmarking and comparisons that you might do with DSO.  CEI is a percentage that expresses the effectiveness of collection efforts over time. The closer to 100 percent, the more effective the collection effort. CEI is ratio that measures the quality of collection efforts over time.  It is essentially the percentage of receivables closed or paid in a given time period. While “Percent Current” has a implied limit of 100%, this is not the case for CEI.

dso_calc2Note: for a definition of credit sales see this post

CEI is a more appropriate measure of performance over time while DSO is for measuring performance at a single point in time. CEI makes comparison with other companies possible  just as DSO does. CEI does not change if a company nets their receivables by removing items they deem disputed and therefore un-collectible.

CEI and DSO should move in opposite directions which makes sense. If your collections efforts increase your DSO should decrease. DSO and CEI can, under certain write off and revenue conditions again, track the same way and thus we have another exception.

This leads us to 2 more performance indicators that are important metrics.

Best Possible DSO

The Best Possible DSO indicates the “best” possible days you can collect on your invoices.  This measure uses the “current receivables” instead of the total receivables balance. Current receivables is the amount of your A/R that is not past due.
The closer your DSO is to the Best Possible DSO, the closer you are to collecting as fast as possible. You should not expect that you ever hit this number as is almost never possible. Assuming you give 30 days term (30 days to pay), if you can get within a 3-5 days of this you are doing really well.

Best Possible DSO = (Current Receivables x Number of Days in Period ) / Credit Sales for Period

(for a definition of credit sales see this post)

Average Days Delinquent (ADD)

Average Days Delinquent (ADD), which is sometimes called Delinquent DSO, calculates the average time from the due date to the paid date. In other words its the average days invoices are past due. It provides a snapshot to evaluate the overall company’s collection performance but it’s also useful at the customer, customer type, collector segment, etc.. This not the same as Average Days To Pay which is based on the historical information of the actual closed invoice while ADD is based on a snapshot in time (Thanks Terry)

Average Days Delinquent (ADD) = Standard DSO – Best Possible DSO

Example

dso_charts1

Summary

In light of the fact that DSO alone does not accurately measure performance in credit and collection, we can now arm ourselves with 2 more indicators for accurately measuring performance; CEI and ADD.  When CEI and DSO track the same way because of revenue fluctuation or changed in terms of sale ADD comes to the rescue and takes both into account.

While DSO has its faults, its is a must have indicator because it is so well understood and enjoys wide acceptance amongst financial professional.  When combined with the ADD and CEI you can truly get a complete performance picture of your accounts receivable.

12 Responses to “Are you collecting your invoices effectively?”

  1. Jim says:

    Thank you for this. I have never seen this laid out so clearly. What is the difference between what you call ADD and an Average Days To Pay calculation?

  2. Average Days Delinquent is calculated based on open AR as was mentioned in Joshua’s article. Average Days to Pay is based on the historical information once the invoices are closed.

    Average Days to Pay from Due Date (example)
    1.First, get the age (in days) and the amount of each invoice for the period (month, quarter, etc)
    2.Second, multiply the value of each invoice by the number of days it took to pay (from due date)
    3.That number represents the Dollar Days Outstanding for each invoice
    4.At the end period, the total dollar days outstanding from invoices collected is divided by the dollars received this yields the average number of days to collect each dollar.

    For more see: http://www.crfonline.org/orc/Average_Days_to_Pay.pdf

  3. [...] out this next post in this to get a couple of alternative ways to measure your [...]

  4. TomT says:

    Best DSO has always confused me because what do you do if you use multiple terms? “Current” is not just net 30 but in our case, it could be net 30/60/90. Does this mean you have to look at every invoice in the current bucket (making it impractical to use). My example:

    One customer with $100 in sales and 30 day terms and one with $100 and 90 day terms have sales in January. My aging at the end of Jan looks like this:

    Total Current Sales BP DSO DSO
    $200 $200 $200 31 31

    But the best I can possibly do is a DSO of 60 if both accounts pay exactly on time. Is there anyway to do the math correctly based on the global dollars in your aging and not pull apart every single invoice?

  5. Hi Tom, We get this confusion a lot so I appreciate the question. you need to look at the numbers over a period of time and use average days delinquent ADD. Best Possible DSO is not a good one to look at without DSO as well thus the ADD to look at for the trend. This will also not work well if you only look at one month in isolation like your example.
    Using your example lets play out 2 months later to end of March and assume each period you did the same thing as you laid out above. assume the 30 terms invoices got paid and of course the 90 days will still be current. You have $100 invoices net 90 for Jan,Feb and Mar. You will have another $100 Net 30 for March. A Total of $400 will be due.
    Your numbers will be
    Total Current Sales BP DSO DSO ADD
    $400 $400 $200 62 62 0

    So 62 is your best possible days sales outstanding and so is your DSO. ADD will be 0
    Now lets say that one of those $100 invoices that were net 30 did not get paid.. then you will have
    Total Current Sales BP DSO DSO ADD
    $500 $400 $200 62 77.5 15.5

    Make sense?
    Again, Its the ADD trend that you want to look at, not the BP DSO. The trend will tell you whats going on and if you get a weird spike in DSO the ADD and CEI will let you know if it is a valid spike. Also, if you have a steady DSO and you see a drop in CEI or a spike in ADD then you also know something is up and the AR is probably not performing. Thats the main point. It works if you are looking at normal steady numbers.

  6. Marcel says:

    I like your article, but I have a question about the presented DSO figures. According to the definition of standard DSO ((Ending Total Receivables / Total Credit Sales) x Number of Days in Period) I get different DSO figures..

    At the end of may I count: 183 days, total revenues for this period = 18831 , ending receivables = 3295. Based on this calculation I get 3295/18831 * 183 = 32 days. Is there a reason why you decided to use the monthly revenue (3295/3089 * 31 = 33,1 day) and not the accumulated one? The same is valid for best possible DSO. Which method of calculation is correct?

    Thank you.

  7. Marcel, you are hitting on one of the problems with DSO and a strong reason why we advocate the CEI and ADD in conjunction. There are a million ways to calculate DSO (ok maybe not a million but its close). Your calculation is technically correct. The question of “Which method is correct” or right is one that has plagued the A/R world for a long time. It also brings into question benchmarking against other companies. Using longer days within reason will usually be close to the 33.1 DSO above if we don’t have big sales spikes. Using higher days can be a good thing as it averages out the sales spikes but again it only really tells us what our DSO is right now. Many companies use the prior 90 days instead of 30 like my example used. The time you use is somewhat arbitrary. You could use 2 years (730 days) if you wanted to but what is that telling you?

    The problem we have with the calculation you did is that it doesn’t take into account the average accounts receivable during that time and thus the impact on a companies cash flow during that time. If I have more money in my back account then I know what to do with then I can easily fund the company for 12 months and don’t care as much how I averaged or trended for the year. But thats not normally the case and DSO was poor at the beginning of the year and hurt my cash flow but your calc using 183 days only shows what we look like right now. Again, always track what the DSO was from month to month so you can trend it. The collections did a good job in Mar,Apr,May to catch up but the numbers didn’t look so good in Dec,Jac,Feb.
    Some companies (like SAP) use what we call an Average DSO calculation (Rolling Average DSO) and snapshot that every month for trending. Usually we try to use 12 months but in this case we will use 6 since we have the data above for an example. This will show you how DSO ran for the 6 months overall.
    (Rolling) Average DSO = average A/R last 6 months / average credit sales last 6 months X 30.5(average days in a month)
    so its 3,138/3,3636 * 30.5 = 35.3

  8. Lisa says:

    I am rolling around an idea I have and wanted to run it by you. Is another way to look at the DSO answer as the number of days sales that is currently sitting in your A/R vs. the average time it takes you to collect it? I ask this, because I am running a calc on a new line of business and only have 30 days worth to calc. The answer I get is 22, but more than 22 days have passed since month end – hence I shouldn’t in theory have anything in A/R. But, I do. I appreciate your thoughts. Great website and blog. It has been very insightful.

  9. Lisa, Thank you for pointing this out. Yes you are correct. From a strictly mathematical perspective traditional DSO is just a ratio of your A/R balance / Avg daily sales and it is as you said – “the number of [average] days sales .. in your A/R”.
    another way to look at it is —
    average daily sales = total sales in period / # of days in period
    DSO or your term DOSIAR(days of sales in A/R :-) ) = A/R balance / average daily sales

    This ratio above points out well why I don’t like traditional DSO alone. Especially if you are a fast growing company. If you are constantly doubling sales every quarter like we have in the past then DSO looks misleading low since average daily sales is growing faster. Its nice to have “the number of days sales in your A/R” but what is that really telling you? At my company, I am most concerned about keeping CEI at 85% or greater and we use the Average DSO calc from my prior comment. We don’t us the old school DSO calc anymore for our internal goals.

    I’ll try to get the blog post up on other ways to calculate DSO this week. I’ll make sure incorporate your point as well in that post

  10. Lisa says:

    Joshua – Thanks so much for your reply. I look forward to your updates!

  11. elizabeth campbell says:

    How does the CEI and other receivable metrics relate to staffing levels? Is there a corresponding formula for outbound collection calls/payments to CEI? I am trying to bridge the gap between our results and number of collectors to determine the appropriate staffing levels.

    Thanks!

  12. Satish says:

    Hi Joshua,

    The DOSIAR & BPDSO are one and the same right, correct me.

    Regards,
    Satish

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