Running a business based on credit is no easy task. You probably have some cash sales to help soften the blow, but standard payment terms of net 60 or net 90 are sure to impact your bottom line. And even with those extended payment terms, some customers still don’t pay on time.
In many industries, it isn’t easy to change standard payment terms. Clients get used to paying a certain way and may be unwilling to budge. So how can you gain visibility into what’s happening today, and what you might do to improve outcomes? Start by gathering up the relevant inputs, so you can measure the effectiveness of your collections process.
First things first: pull together all your customer payment terms and history of payments on invoices. This information should be available in your accounting or invoicing software, possibly with an export function. If you’re lucky, the metrics we’re recommending below may be available in your software in graphical form. And if not, you can always extract the appropriate data and configure some charts and graphs in a spreadsheet.
As you’re starting this process, make sure to have a timeframe in mind that will give you enough data to draw conclusions. 30 days isn’t nearly enough, as many of your customers’ payment cycles are much longer. A full year will give you a more accurate picture, and multiple years can give you even more insight. Being able to compare year-over-year data is powerful. Are there seasonal changes that happen in your collections process? Has collections improved or deteriorated over a number of years?
Now that you have your data, calculate these 2 metrics to start and review the results:
Days Sales Outstanding (DSO) measures the number of days it takes a business to collect on credit sales. It is generally calculated on an annual basis, and looks like this:
Accounts Receivable for 2016: $200,000 ---------- X 365(days per year) = 73 DSO Net Credit Sales for 2016: $1,000,000
The most common goal here is to get DSO as close to your payment terms as possible. So if your payment terms are net 60 and your DSO is 73, you can work towards closing the gap.
Collection Effectiveness Index (CEI) shows how much your company was owed and how much was collected in a specific time period (also commonly measured on an annual basis). CEI really illustrates the performance of your overall collection strategy. The closer it is to 100%, the better.
CEI is slightly more complex, in that there are multiple inputs in the ratio. Here’s an example for a specific month:
Receivables total(start of April) + invoice revenue for April - total receivables(end of April) ---------------------------------------------------------------- X 100 Receivables total(start of April) + invoice revenue for April - current receivables(end of April)
And what’s the difference between DSO and CEI? DSO is a measure of time, telling you how long it takes to collect credit payments. CEI takes a longer view, showing you how effective your collections policy is.
Understanding these collection-specific metrics can be really eye-opening - in a positive or negative way. Before you make any judgments based, compare it to industry benchmarks. At the outset, your collections performance may look weak - until you look at similar companies in your industry. And even if it still looks poor, remember that this data is based on your unique business and all its facets. Take into consideration all factors where your business may be different from others in your industry.
If you want to drill down further, there are additional metrics like Accounts Receivable Turnover Ratio (ART) and Average Days Delinquent (ADD) that will help you pinpoint the problem. But first, develop your understanding of your business’s collection status today.