Day sales outstanding (DSO) is the average number of days it takes to convert credit sales to cash. In other words, it is the average number of days taken by a company to collect its receivables after a sale. DSO is one of the key metrics used by experts to measure the financial health and performance of a company.
The formula to calculate DSO is :
A company ABC makes around $20,000 credit sales and $10,000 accounts receivables in 40 days. Now, let’s calculate its DSO.
It means that company ABC recovers its dues in 20 days.
High DSO suggests that the company takes a lot of time to collect its dues. It indicates the lack of an efficient collection and credit analysis process. A business with high DSO often fails to convert the receivables into cash and in some cases, it may even have to write it off bad debt.
Let’s look into some strategies to optimize DSO.
You can effectively reduce DSO by providing customers with convenient payment options. For example, a self-service customer portal where customers can pay via their preferred payment options (such as credit card payments, ACH payments) helps reduce DSO. It also helps customers keep track of all invoices, pay multiple invoices at once, and raise disputes.
By offering discounts you can incentivize customers to pay early, hence reducing DSO. Additionally, some late fees can also be applied if a client fails to pay past the due date.
For SMBs, it is very crucial to track risky customers. By periodically evaluating customer worthiness you can update credit limits based on their risk levels. You can prioritize collections for risky customers to avoid bad debt and maintain a healthy cash flow.
High-risk clients are accounts that require immediate follow-ups as any negligence might result in bad debt. It is very important to identify high-risk accounts and open communications requesting payments before it is too late.
Tracking key high-risk accounts is crucial to measuring the operational efficiency of a company. By segmenting the customers based on various factors such as DSO, credit limit, aging buckets, or past payment history trends, we can create worklists that will help identify priority accounts for dunning and cash collections. All these efforts will eventually help reduce the risk of bad debt.
Let’s look at some effective strategies for customer segmentation.
By prioritizing customers based on aging, i.e. the time period for which payments are due, businesses can identify accounts that are overdue for a long time and make strategies to collect them as early as possible.
Customers can be segmented based on their payment history. This will help bucket on-time payers and late payers separately.
This will help segment customers based on their order value. You can then identify the large paying customers from others.
As the name suggests, the collection effectiveness index (CEI) is the measure of how effective one is in collecting their outstanding money in a given time period. It measures the performance of your O2C team and enables you to decide if your current collection policies need to be changed. A higher CEI indicates that you have strong credit policies and an effective collections system.
CEI is not a measure of time like DSO. It is the measure of your business’s ability to convert invoices into cash.
CEI is calculated with the help of the following formula which shows how much of the receivables were collected out of what was supposed to be collected.
The beginning AR of an organization is $8000, and the credit sales are $16,000. The ending AR is $6200, and the ending current AR is $4000. Therefore, the CEI for three months would be 81%.
Let’s look into some strategies to increase CEI.
Segmenting customers based on their risk level helps increase the effectiveness of the collections process. It enables us to keep track of all the different risk buckets and proactively reach out to customers for payments and periodic reminders.
Proactive dunning empowers collectors with pre-defined correspondence templates. It helps your team automatically send periodic reminders to customers requesting payments. It also allows you to keep track of payment commitments, hence improving the efficiency of collections.
Credit policies should be designed keeping in mind the financial health and payment performance of the company. Credit policies should include credit limits, credit terms, information to be collected from clients for credit approval, invoicing terms, and debt collection terms. For example, a company might have a strict 30 days payment policy for a high-risk account. This will help make collections faster and reduce the risk of bad debt to the company.
You can effectively increase CEI by providing customers with self-service portals where they can pay with their preferred payment options(like card payments, ACH payments). Customers can also keep track of all the invoices, pay multiple invoices at once, and raise disputes on the invoice(s). If your finance team is not supporting multiple payment options, it would be easier for the customers to make excuses and delay the payment. This would reduce your cash flow and result in higher bad debt.
A periodic credit review is an assessment conducted at specified time intervals by lenders on their key customers. This helps them to update their credit scores at regular intervals and stay on top of the credit-risk portfolios of customers.
For example, suppose company B has previously failed to pay you on time. In such a case, a periodic credit review will suggest we limit the credit to company B, thus reducing the chance of bad debt. This helps in evaluating the creditworthiness of key customers, securing receivables, and extending appropriate credit limits.
By keeping track of customers’ annual turnover we can compare the current financial health of the company with previous years. This helps to predict the creditworthiness of the company. It also helps to modify the credit limits offered to the company as per their financial growth in the current accounting period.
We can evaluate the creditworthiness of existing customers by evaluating their payment history. This helps to modify the credit limit of existing customers based on risk levels.
Credit agencies help lenders by providing information on whether a company should be given credit or not based on their financial health, previous payment records, collaterals, and the state of the economy. This information in return helps us to reduce the risk of bad debt.
One can determine whether to lend credit to a company or not based on trade references given by the company they have previously borrowed from or worked with.
Finance teams in small and mid-sized companies are often burdened with multiple tasks. The team is small often finds it difficult to manage the tasks manually, resulting in oversight in certain important areas. By tracking and optimizing the above-mentioned AR metrics you can drastically reduce the chances of bad debt and poor cash flows. Moreover, these metrics also provide visibility across all AR operations, thus supporting faster revenue growth.
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