A Framework for Choosing Suitable AR Metrics
Businesses should carefully assess their specific needs, objectives, and operating context when selecting metrics for accounts receivable (AR) performance measurement. The chosen metrics should provide relevant and actionable insights to support strategic decision-making, financial management, and operational improvement initiatives in light of the following issues:
Business Model and Industry: Different industries and business models have unique characteristics that may require different metrics for effective AR performance measurement. For example, a manufacturing company may prioritize inventory turnover and cash flow efficiency, while a service-based company may focus more on client payment cycles and cash conversion.
Financial Health Priorities: Organizations may have specific financial health priorities such as improving liquidity, managing working capital, or reducing credit risk. The choice of metric should align with these priorities to provide meaningful insights and support decision-making processes.
Stakeholder Requirements: External stakeholders such as investors, creditors, or regulatory bodies may have specific reporting requirements or preferences for certain metrics. Organizations may need to consider these stakeholder expectations when selecting metrics to ensure transparency and compliance.
Operational Limitations The availability of data, resources for data collection and analysis, and organizational capacity to implement and interpret metrics should also be taken into account. Metrics that require extensive data gathering or complex calculations may not be feasible for organizations with limited resources or capabilities.
Strategic Objectives: The strategic objectives of the organization, such as growth, profitability, or risk mitigation, can influence the choice of metrics. Metrics should provide insights that are aligned with these strategic goals and help monitor progress towards achieving them.
Short-term vs. Long-term Focus: Some metrics may be more suitable for short-term monitoring and decision-making, while others may provide insights into long-term trends and performance. Organizations should consider whether they need metrics that offer immediately actionable insights or those that provide intel that can be applied over longer time horizons.
Comparative Analysis: The choice of metric may also depend on the need for comparative analysis with industry peers or benchmarks. Metrics that are commonly used in your industry or are standardized for benchmarking purposes may be preferred in such cases.
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The Limitations of DSO
Days Sales Outstanding (DSO) is widely used to assess the efficiency of a company's AR management. DSO formulas looks at sales volume during a period of time set against the ending AR balance to provide a measure of receivables turnover. A major problem with this formulation is that consistently rising or falling sales can skew the output even when collections are consistent. Like any metric, DSO has limitations. Here are seven weaknesses:
Doesn't Capture Collection Efforts: DSO only measures the average number of days it takes for a company to collect its accounts receivable. It doesn't provide insights into the effectiveness of the company's collection efforts or the quality of its receivables.
Lack of Context: DSO doesn't provide context regarding the reasons behind fluctuations. For example, a high DSO can result from credit policies, economic downturns affecting customers' ability to pay, or inefficiencies in the collection process. Similarly, a low DSO might indicate aggressive collection efforts, stringent credit policies, or a high proportion of cash sales.
Seasonality and Cyclical Trends: DSO may fluctuate due to seasonal or cyclical factors that don't necessarily reflect the company's overall performance. For instance, businesses may experience longer DSO during holiday seasons or industry-specific downturns.
Varied Industry Standards: Different industries may have different DSO benchmarks due to variations in payment terms, customer behavior, and business models. Comparing DSO across industries may not provide meaningful insights.
Inaccuracy Due to Large Customers: DSO can be skewed by a few large customers who may also have longer payment terms. This can distort the overall picture of accounts receivable performance, especially if these customers are significant to the business.
Doesn't Account for Bad Debts: DSO doesn't differentiate between collectible and noncollectable receivables. A company may have a low DSO but still face significant losses due to bad debts. In fact, writing off bad debts will lower your DSO.
Doesn't Consider Cash Flow: While DSO is a useful indicator of how quickly receivables are being collected, it doesn't directly reflect the impact on cash flow. A company may have a low DSO but still face cash flow problems if customers pay late or if there are other liquidity issues.
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Five Supplements to DSO
To overcome the limitations inherent to DSO, it's important to complement DSO with other metrics and qualitative analysis to gain a comprehensive understanding of accounts receivable performance. These may include metrics related to credit risk, collection efficiency, aging schedules, and customer satisfaction. Here are five alternative metrics that provide context for and generate additional insight relative to DSO.
Weighted-Average Terms (WAT):
A good place to start your analysis involves calculating the average number of days you are offering by granting customers open credit. By calculating WAT, companies can analyze whether customers are adhering to the agreed-upon payment terms or if there are deviations. If your AR contains 100 open invoices on Net 30 day terms and and 50 more invoices on Net 60 day terms your WAT will be 40 — the calculation is (100 X 30 + 50 X 60)/150. If your DSO is 43, you are doing well. If DSO is 49, then not so much.
WAT provides insight into the average contractually-agreed payment terms between a company and its customers allowing businesses to understand the impact of extending or shortening payment terms offered to customers. The impact of varying time periods and sensitivity to sales trends on DSO can be mitigated by using WAT to provide a more comprehensive view for working capital analysis.
Weighted-Average Days to Collect (WADTC):
Similar to Weighted-Average Terms, WADTC measures the average number of days it takes for customers to pay their invoices, but also takes into account the size of each invoice. This metric measures how long it takes a customer to pay its invoices and is weighted according to the size of each invoice. Current ERP and accounting systems collect the data necessary to make this calculation for every paid invoice — the tough part is multiply the amount of each invoice by the number of days it took to collect it.
Taking the example used for calculating WAT, and assuming invoices are being paid on the due date, if your 100 Net 30 invoices account for $500,000 in revenue and the 50 Net 60 invoices another $350,000, your WADTC will be 42.4. In other words, it should take you nearly 43 days to collect your entire $850,000 receivable. In comparison, a 43 day DSO is looking really good, while the 49 day DSO does not seem as problematic.
WADTC provides a more nuanced understanding of payment patterns compared to traditional DSO calculations. By weighting each invoice based on its value, it helps identify deviations in payment patterns, allowing businesses to address potential issues promptly. WADTC is used to compare payment performance among different customers or customer segments over time. By analyzing WADTC trends, companies can then optimize their collections strategies and allocate resources more effectively to improve cash flow.
A comparable alternative to WADTC is Best Possible Days Sales Outstanding: BPDSO = (Total Accounts Receivable / Total Credit Sales) X Number of Days in Period. Similar to WADTC, BPDSO provides an estimate of the numbers of days to collect the AR if every customer paid on time.
Rolling Average Days Sales Outstanding (RADSO)
RADSO is used to evaluate the efficiency of a company's accounts receivable management over a period of time. This could be a month, a quarter, or a year, depending on your analysis requirements. To calculate RADSO, follow these steps:
Determine the total accounts receivable (AR) at the beginning and end of the period you're interested in.
Calculate the total credit sales made during the same period.
Use this formula below to calculate the average accounts receivable turnover ratio for the period: Average Accounts Receivable Turnover Ratio = (Beginning AR + Ending AR) / 2
Calculate the Average Daily Sales by dividing the total credit sales by the number of days in the period: Average Daily Sales = Total Credit Sales / Number of Days in Period
Finally, compute RADSO using the formula: RADSO = Average Accounts Receivable Turnover Ratio / Average Daily Sales
Repeat this calculation for each period, rolling forward as time progresses, hence the term "rolling" average.
RADSO provides a dynamic view of the company's collection efficiency over time, smoothing out fluctuations and providing a more stable measure. It helps mitigate the impact of seasonal or one-time fluctuations in sales or collections. By analyzing it over multiple periods, you can identify trends and assess the effectiveness of the company's credit and collection policies. A decreasing RADSO generally indicates improvement in collections, while an increasing RADSO may signal issues with credit management or collection efforts.
Collection Efficiency Index (CEI)
Comparing actual collections to expected collections enables you to assess the effectiveness of a company's accounts receivable management. Very simply, CEI provides insight into how well a company is converting its outstanding accounts receivable into cash. The formula for calculating CEI is as follows:
CEI = (Beginning AR - Ending AR - Credit Sales for the Period) / (Beginning AR - Ending AR) X 100
CEI measures the percentage of expected collections that were actually collected during the period. A CEI of 100 percent or higher indicates that all expected collections were collected, while a CEI of less than 100 percent suggests that collections under-performed, signaling issues with credit policies, collection efforts, or customer creditworthiness. By monitoring CEI over time, you can identify trends, assess the impact of changes in credit and collection practices, and take corrective actions to improve cash flow and working capital management.
Cash Flow Adequacy Ratio (CFAR)
CFAR is used to assess a company's ability to cover its short-term liabilities or financial obligations using its operating cash flow. It's a measure of liquidity and financial health. To calculate the CFAR, follow these steps:
Determine the company's operating cash flow, cash generated from the company's core business operations and typically found in the company's statement of cash flows, for a specific period.
Sum up all the company's short-term liabilities or financial obligations — these may include accounts payable, short-term loans, accrued expenses, and other obligations that are due within a year.
CFAR = Operating Cash Flow / Total Short-Term Obligations
Analyze CFAR over time and in comparison to industry benchmarks to assess a company's liquidity position and financial health.
CFAR indicates how many times the company's operating cash flow covers its short-term obligations. A CFAR greater than 1 indicates that the company generates sufficient cash flow to cover its short-term liabilities, while less than 1 suggests that the company may have difficulty meeting its short-term obligations with its current cash flow. In that case, you may want to calculate how much you will need to improve DSO to raise CFAR to a sustainable level. By monitoring CFAR, you can gain insights into a company's ability to manage its immediate cash flow needs and make informed decisions regarding financial operations and strategies.
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In Summary . . .
In comparison to DSO, these alternative metrics offer different perspectives on accounts receivable management and a company’s overall financial health. While DSO focuses specifically on accounts receivable turnover, metrics like WAT, WADTC, RADSO, CEI and CFAR provide broader context or additional insights into cash flow, working capital management, and overall financial performance. However, they may also be more complex to calculate, interpret, or maintain compared to the straightforward nature of DSO.
By incorporating these metrics, businesses can gain a deeper understanding of payment behaviors, contractual terms and AR performance than DSO alone would provide. A more comprehensive understanding of working capital and collections performance, facilitates better decision-making and enhancing cash flow management. Ultimately, because of the variety of business enterprises, your choice of metric will depend on the specific needs and objectives of your organization.