Let’s state right away, if your business runs on mostly counter
Wondering when or if you are going to get paid?
sales collecting cash, debit card, credit card, and check payments you can skip this posting. This one is for businesses who sell on credit.
In the economy we have experienced the last few years, it seems cash is king. Those who have cash, businesses and people alike, feel more secure, are willing to take more risks, and are in a position to take advantage of emerging opportunities. Investors have rewarded companies with growing cash balances. Turning your credit sales into cash more quickly is an urgent goal. Factoring services have grown significantly and I don’t think a week goes by when I don’t get a call from a new credit reporting company or collection agency who wants to help me get Accounts Receivable turned into cash faster.
How do you know if you need to hire one of these groups? Are you collecting quickly enough? Can you do better? Are your credit and collection systems improving? Did the new collection agency really help?
Answer these question by using one of several metrics for measuring your efficiency at turning Accounts Receivable into Cash:
AR Turnover = Total Credit Sales / Average AR Balance
This measures how many times your receivables are billed and collected within a period. This metric is usually published as turnover per year. If you use annual data, be sure to get a true Average AR Balance over the 12 months or, 4 quarters. Don’t rely on just your year-end AR balance, since companies are usually ultra-vigilant of AR balances for year-end presentation and this may not reflect the usual balances that occur during the year. If you measure on a shorter than 1-year time frame, be sure to annualize the metric before benchmarking against other companies.
Days Sales Outstanding = (AR Balance/Credit Sales for the Period) x Days in the Period
This measures how many days your average account is outstanding before you collect cash. I like this metric because you can effectively use it for any period that corresponds best to your business; you just multiply it by the days that correspond to the period you are measuring and the answer adjusts to your needs. This metric is really great for trending month-to-month or even week-to-week data, whatever best matches your business cycle. If you are trying out a new collection technique or credit screening process you can get data results pretty quickly by selecting the right measurement period and calculating both pre-change and post-change metrics.
Perhaps you are feeling pretty good about yourself when you benchmark your Days Sales Outstanding (DSO) against your competition. If so, maybe you need to do one more calculation and bring yourself back to earth. Try:
Best Possible DSO – (Current AR Balance/Credit sales for the period) x Days in the Period
This one looks at what your DSO would look like if you collected all of your AR within terms. It is usually a number less than the days in your invoice payment terms since many customers pay in less time. Usually, it will bring you back to earth a little and may make you start dreaming, “What if we were able to make that number….?” “What could we improve in our process to get a little closer…?”
Things to keep in mind:
- As usual, don’t compare these metrics to companies outside your industry. Yes Pharma and Freight companies collect a lot faster than Equipment Manufacturing companies, Food Distribution collects even faster. Knowing that doesn’t help you manage your customers or optimize your resources.
- Be careful about compensating based on this metric alone. Always look at the trend over time to measure your success. Be sure no end of period manipulation of balances is occurring. Calculate the metric over varying periods, weekly, monthly, quarterly, yearly to check for consistency in your results.
- Every so often compare your DSO to your Best Possible DSO to keep your eye on the prize. It is good to consider what your cash flow would look like in a perfect world where everyone pays their bills before the due date. Ahhhh, Nirvana!
THE PRACTICAL MANAGER 
Great information about A/R and cash flow! Very nice post and blog. I love statistics and formula so I very much enjoy this blog… definitely a follow!! Thanks!