4 Accounts Receivables Metrics That CFOs Should Track and Measure

What you’ll learn


  • Important AR metrics that improve efficiency and make the finance team’s job easier
  • Impact of tracking AR metrics such as DSO, credit scores, aging accounts, and CEI
  • Best AR practices to create for strong bottom-line growth

Introduction

Finance executives at small and mid-sized businesses (SMBs)are likely to find it difficult to manage receivables with small AR teams. AR teams at SMBs tend to spend most of their time managing tasks manually. This leaves them with little time to focus on high-value functions such as credit, collections, and strategic financial planning. Moreover, it becomes difficult for them to keep track of important performance metrics like cash flow, working capital, DSO, and annual turnover, thus impacting business development.

We, at HighRadius, spoke with financial experts in the mid-market segment to compile some key AR metrics that impact the bottom line.

Let’s look into some key accounts receivable metrics that will help you keep your AR operations at the top of your game.

Essential AR metrics

Day sales outstanding (DSO)

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.

Impact of outdated AR process

Source: Paymentsjournal

How is DSO calculated?

The formula to calculate DSO is :

DSO formula

For Example

A company ABC makes around $20,000 credit sales and $10,000 accounts receivables in 40 days. Now, let’s calculate its DSO.

How to calculate DSO

It means that company ABC recovers its dues in 20 days.

Why is DSO an important metric for evaluating operations effectiveness :

  • DSO is directly related to collections. Faster cash collections from customers lead to increased cash flow.

  • This means the same money can be allocated to different high-value purposes.

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.

How to Optimize DSO?

Let’s look into some strategies to optimize DSO.

Ways to optimize DSO

  • Providing multiple payment options

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.

  • Offer discount to early paying customers

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.

  • Identify at-risk customers

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.

Track high-risk accounts

What is a high-risk account?

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.

How can tracking high-risk accounts help?

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.

How to track high-risk accounts?

Let’s look at some effective strategies for customer segmentation.

Ways to track high-risk accounts

  • Aging buckets:

    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.

Aging bucket formula

  • Payment performance:

    Customers can be segmented based on their payment history. This will help bucket on-time payers and late payers separately.

  • Value to the company:

    This will help segment customers based on their order value. You can then identify the large paying customers from others.

Collection effectiveness index (CEI)

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.

impact of declining CEI

How is CEI Calculated?

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.

CEI formula

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%.

collections are challenging

Sources: PYMNTS

How to Increase CEI?

Let’s look into some strategies to increase CEI.

Methods to increase CEI

  • Customer Segmentation

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

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.

  • Standardized credit policies

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.

  • Providing multiple payment options

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.

Periodic Credit Reviews

What is periodic credit review?

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.

Essential information needed for periodic credit reviews

Essentials for periodic credit review

Annual Turnover:

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.

Payment history:

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 data aggregation from credit agencies:

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.

Trade references:

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.

Summary

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.

Click here to know how you can drastically reduce AR operational costs and strengthen working capital.

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