By Dean Kaplan, CEO and President, The Kaplan Group
While many CFOs are well-versed in ROI, tracking and controlling expenditures, accounting rules and all the other elements of a company’s bottom line, some are uninformed about collections and the collections process. For companies that extend credit to their customers, accounts receivable can be one of the largest assets on the balance sheet. Making sure this asset is healthy should be a high priority. You want to regularly turn it into cash critical for the businesses’ success. A poorly managed accounts receivable department can lead to slow payments, cash flow issues, and unnecessary losses.
What to Track
There are two metrics commonly used to measure collection performance.
The Days Sales Outstanding (DSO) ratio shows how many days, on average, it takes you to collect on your sales. DSO is calculated by dividing accounts receivable by the total value of credit sales during the same period. Then, multiplying the result by the number of days in the period measured. For example, if sales on credit average $10 million per month and your accounts receivable balance is $20 million, your DSO is $20M/$10M x 30 days = 60. This is a key measure in being able to forecast cash flow.
Higher DSO means it takes longer to turn sales into cash, requiring the company to have more working capital. It may also be an indicator that management is not focusing on keeping accounts receivable in line. Or, that the company sells to riskier customers or is giving longer terms to obtain sales.
It is important to look at DSO not only at a single point in time to measure current effectiveness and risk, but also over time to measure performance. If DSO is increasing, this could be a red flag. If DSO decreases, especially in comparison to competitors, this may indicate that the company’s credit risk policy is too conservative. The company might be missing viable sales opportunities.
Another key metric is the Collection Effectiveness Index (CEI). CEI is a calculation of a company’s ability to collect money from their customers. While DSO provides a good cash flow measurement, CEI specifically targets collection proficiency. To calculate CEI, compare the amount collected in a given period to the amount of money that could possibly be collected. You can determine the total amount of potentially collectable receivables by adding the beginning accounts receivable balance and monthly credit sales and then subtracting the ending total receivables balance. Divide the denominator. Calculate the denominator by adding the beginning accounts receivable balance and monthly credit sales and then subtracting the ending current receivables balance.
For example, if beginning receivables was $20 million, monthly credit sales was $10 million, ending total receivables was $22 million and ending current receivables was $18 million, the CEI would be ($20M + $10M – $22M)/($20M + $10M – $18M) = 67%. A CEI of 80% to 90% is considered satisfactory. A lower CEI typically is an indication of problems in managing accounts receivable and possibly also the collection process.
How to Fix a Problem
Imagine your CEI is at 50%, or perhaps it was previously at 85% and is now at 75%. You know you need improvement, but the first thing to do is figure out what is causing the problem.
Is it a problem in your invoicing or collection process? Are invoices going out quickly and accurately? Do you snail mail invoices or send them electronically? Are you confirming with your customers that they have received the invoices? Do you follow up immediately after they were due and consistently thereafter? Are you dealing with problems quickly? Do you escalate pressure as soon as you realize you can’t solve the problem?
Or perhaps DSO is high while CEI is good? This indicates that possibly your credit risk policy or evaluation process has changed. Is your sales force compensated at the time of sale or when money is collected? Are you asking for deposits up front to keep DSO lower?
Using a Collection Agency
No matter how good your policies and procedures are, any company that sales on credit will eventually have unpaid receivables. By the time an invoice is 90 days past due, there is a 25% chance it will never get paid. If it gets to one year old, there is only a 27% chance it will ever get collected. While this may represent only a small fraction of credit sales, if you don’t take action it is lost revenue.
Most reputable collection agencies charge on a contingency basis. Sending your invoices to a collection agency is a risk-free way of getting the money you are owed. Using a collection agency for older invoices can improve your DSO and CEI. A collection agency can free up your Accounts Receivable staff to work with your paying customers. This allows your customers to keep purchasing more from your company.
The collections process is an important part of your bottom line. Just like lawyers and accountants, collection agents can be important partners for your business.
Dean Kaplan is president of The Kaplan Group, a commercial collection agency specializing in large claims and international transactions. He has 35 years of manufacturing, international business leadership and customer service experience. Today, he provides business planning, training and consultation to a variety of global companies.