In the captivating world of finance, where numbers dance and money talks, understanding and effectively utilizing key performance indicators (KPIs) is essential for optimizing cash flow and achieving sustainable success.
Picture this: your business's financial health soaring to new heights, like a majestic eagle riding the wind of profitability. But this journey requires the secret sauce – the perfect blend of Accounts Receivables mastery and the right set of KPIs.
Accounts Receivable (AR) is like the fuel tank of your financial vehicle, driving your company forward. However, without the right KPIs, it's like driving the vehicle without a fuel gauge – you may have no clue how much fuel you are left with. This may make it difficult for you to plan the journey ahead and avoid running out of fuel.
That's exactly what we want to address in this post. Brace yourself for a riveting exploration of the top 8 Account Receivables KPIs that will guide you toward financial triumph.
We're talking about insights that will give you the power to navigate the dynamic landscape of receivables management with confidence. Let's dive in!
Accounts Receivable KPIs are metrics that businesses use to measure the effectiveness and efficiency of their AR management process. These metrics provide insights into how well a business is managing its credit and collections and how quickly it is converting AR into cash.
AR KPIs serve as the compass in financial management, guiding businesses toward optimized cash flow and sustainable success. These KPIs act as powerful indicators, illuminating the path to enhanced cash flow management and unlocking growth opportunities.
There are several AR KPIs and we shall be discussing a few key ones in detail in this post. Stay tuned to read more!
The importance of Account Receivables KPIs in financial management cannot be overstated. These metrics play a vital role in optimizing cash flow, ensuring financial stability, and driving business success. Here's a brief overview of the key reasons why Account Receivables KPIs are crucial:
- Cash Flow Optimization: AR KPIs provide valuable insights into the speed and efficiency of payment collection, enabling businesses to identify bottlenecks, reduce payment delays, and improve cash flow.
By tracking metrics like Days Sales Outstanding (DSO) and Average Collection Period (ACP), businesses can take proactive measures to accelerate cash inflows and enhance liquidity. - Risk Mitigation: Account Receivables KPIs help identify potential risks such as late payments, bad debt, or customer default. Metrics like the Aging of Receivables and Bad Debt Ratio enable businesses to assess how creditworthy the customers are and implement strategies to minimize risks.
- Strategic Decision Making: Businesses can gain valuable data-driven insights by monitoring AR KPIs. These metrics offer a clear picture of invoicing efficiency, collection effectiveness, and overall receivables performance.
With this information, businesses can make informed choices regarding credit policies, resource allocation, and collection strategies to drive growth and profitability. - Performance Evaluation: Account Receivables KPIs serve as benchmarks for measuring and evaluating the performance of receivables management. Comparing metrics against industry standards or historical data helps businesses gauge their efficiency, set realistic goals, and identify areas for improvement.
This aids in the continuous evaluation and refinement of receivables processes for better financial performance. - Customer Relationship Management: Effective management of accounts receivables leads to better customer relationships. Timely and accurate invoicing, proactive communication, and efficient collection processes build trust and credibility with customers.
By tracking AR KPIs, businesses can identify customer payment patterns, address payment issues promptly, and maintain healthy customer relationships.
Now that we understand the importance of Account Receivables KPIs let’s check out the top 8 Account Receivables KPIs one should consider driving business growth.
Days Sales Outstanding (DSO) is a key financial metric that measures how long a company takes to collect payment after a sale. It's calculated by dividing the total accounts receivable balance by the average daily sales revenue.
Below is the formula-
DSO = (Accounts Receivable / Total Credit Sales) * Number of Days in the Period
For example: A company has total net receivables of $50,000 at the end of the year. The company's total credit sales for the year were $500,000.
Let’s apply the DSO formula-
DSO = ($35,000 / $650,000) * 365 = 19.6 days
So in this example, the company's DSO is 19.6 days. This means that the company takes 19.6 days on average to collect payment post a credit sale.
DSO is a measure of the effectiveness of a company's credit and collection efforts. If DSO is getting longer, it could mean that the company's collection processes are not effective or that customers are having trouble paying their bills on time. On the other hand, a short or decreasing DSO could indicate that a company is efficient in collecting receivables.
The Collection Effectiveness Index (CEI) is a performance metric that measures how effective a company's accounts receivable collection efforts are over a specific period of time.
The CEI takes into account both current and overdue accounts receivable. As a result, it provides a more comprehensive measure of collection effectiveness relative to the other metrics. It gives you a clearer picture of how well your business is doing at collecting owed money, regardless of whether those debts are recent or more longstanding.
The CEI is calculated as follows:
[(Beginning Receivables + Monthly Credit Sales - Ending Total Receivables) / (Beginning Receivables + Monthly Credit Sales - Ending Current Receivables)] * 100
A higher CEI indicates more effective collection activity. A CEI of 100% would mean that all receivables (both current and overdue) were collected in the period.
It's important to monitor the CEI regularly to ensure your collections process is effective and to identify any potential issues early. If your CEI is declining, it might be time you need to review and possibly improve your collections strategies.
Should your team be facing challenges in optimizing collections efficiency, it could be beneficial to enhance your invoice monitoring mechanisms. This can prevent instances of customer payments going unnoticed or unrecorded.
Consider deploying an automated system like Constant for managing accounts receivables, which can help maintain comprehensive and up-to-date tracking of invoices.
The Accounts Receivable Turnover Ratio is a key financial metric that assesses how efficiently a business is able to turn money into cash. The ratio is reflective of the efficacy of the company's credit policies and collection efforts.
The Accounts Receivable Turnover Ratio is calculated by dividing the net credit sales by the average accounts receivable during the same period.
The formula is as below:
Accounts Receivable Turnover Ratio = Net Credit Sales / Average Accounts Receivable
For example: A company has total net credit sales of $800,000 during the year. The average accounts receivable during the same period is $100,000.
Let’s apply the ART formula-
ART = $800,000 / $100,000 = 8 times
This means that the company's Accounts Receivable Turnover Ratio is 8. This suggests that the company collects its average receivables 8 times in a year.
A higher Accounts Receivable Turnover Ratio indicates that the company has strong collection processes in place and is able to turn its receivables into cash quickly. A lower ratio might suggest that the company may not be capable enough of collecting its receivables and may have too many old, outstanding invoices.
Another key metric is the Bad Debt to Sales Ratio. It indicates what percentage of a company's sales is not collected that is eventually written off as bad debt. In other words, it's the money that customers owe to the company but they are unable to pay.
The Bad Debt to Sales Ratio is calculated using the following formula:
Bad Debt to Sales Ratio = (Bad Debts / Total Sales) * 100
For instance: A company has made total credit sales of $1,000,000 in a year. The company’s bad debt is $10,000.
Let’s apply the formula:
Bad Debt to Sales Ratio = ($10,000 / $1,000,000) * 100 = 1%
Here, the company's Bad Debt to Sales Ratio is 1%, which means that 1% of the company's total credit sales for the year was written off as bad debt.
The higher the percentage, the larger would be the portion of the company's sales being written off as bad debt, which could indicate problems with the company's collection efforts or credit policies.
On the contrary, a lower Bad Debt to Sales Ratio might suggest that the company's customers are generally reliable and pay their bills on time and that the company has effective credit and collections policies in place.
The Write-off Ratio measures the amount of debt a company is unable to collect and has therefore decided to write off. This may possibly happen when all reasonable attempts to collect the debt have been exhausted.
The write-off ratio is calculated with the help of the below formula:
Write-off Ratio = (Total Amount Written Off / Total Amount of Debt) * 100
For example: if you had a bad debt expense of $200 and an accounts receivable balance of $2000, your write-off ratio would be 10%.
($200 / $2000) x 100 = 10%
Ideally, every company aims to have the write-off ratio as low as possible.
A higher Write-off Ratio suggests that a larger proportion of the total debt is being written off, which could indicate issues with the company's credit policies or its ability to collect debt. It could also suggest that the company or financial institution is extending credit to customers or borrowers who are not creditworthy.
Whereas a low Write-off Ratio indicates that the company has effective credit and collection policies in place or that it only extends credit to reliable customers or borrowers.
Average Days Delinquent (ADD) tells us the average number of days a customer takes to pay their invoice after it’s due. It means payments are often late, and the company might need to get better at collecting back the money it owes to its customers.
The formula to calculate ADD is:
ADD = (Total Number of Days Past Due / Total Number of Invoices Outstanding)
Suppose a company has three invoices that are past due:
- Invoice 1 is 10 days past due
- Invoice 2 is 15 days past due
- Invoice 3 is 20 days past due
Let’s apply the formula to calculate the ADD-
ADD = (10 days + 15 days + 20 days) / 3 invoices = 15 days
This means that, on average, payments are 15 days late for this company.
Ideally, a lower ADD is better because it indicates that, on average, receivables are less delinquent. A higher ADD could suggest issues with the company's credit policies or collections processes or that customers are probably slow to pay their bills.
Operational Cost per Collection is an important metric that measures the cost a company incurs to collect its receivables. It includes all the operational expenses like employee salaries, the cost of collection software and other technology, postage for mailing invoices and reminders, or any other expense associated with receiving payments from customers.
To calculate the Operational Cost per Collection, you would divide the total operational cost of the collections department by the total amount collected during the same period.
Here's the formula:
Operational Cost per Collection = Total Operational Cost of Collections / Total Amount Collected
This metric helps a company understand how much it is spending to collect its receivables. A higher value may suggest inefficiencies in the collections process, while a lower cost could indicate a more efficient process.
Overcoming the substantial costs associated with collection activities can be achieved by capitalizing on accounts receivable automation software like Constant.
Harnessing automation's capabilities can enhance your accounts receivable performance indicators while reducing collection expenses. This is made possible by automating functions such as reminders for payments, issuance of customer statements, and verification of payments, among other tasks.
Deduction Days Outstanding (DDO) is a financial metric that measures the average time a company takes to resolve customer deductions or discounts. Deductions could include things like returns, allowances, or promotional discounts that the customer deducts from the amount they owe the company.
Here's the formula to calculate Deduction Days Outstanding:
DDO = (Total Deductions / Total Credit Sales) * Number of Days in the Period
A shorter DDO is ideally better because it suggests that the company is able to resolve deductions quickly, which can result in an improved cash flow. A longer DDO could indicate that the company is slow to resolve deductions, which could tie up cash and create uncertainty about the company's revenues.
In summary, efficient accounts receivable (AR) management is critical for maintaining and improving a company's cash flow. There’s no gainsaying that the best way to manage AR effectively is by monitoring the essential AR KPIs
Companies must also establish targets for each KPI and develop strategies to achieve these targets. In addition, companies need to understand that while each of these KPIs is important, they must be viewed and analyzed collectively rather than in isolation to get a clear and accurate picture of the company's AR performance.
And remember, the journey to improved cash flow through better AR management is a marathon, not a sprint. Patience, consistency, and continual adaptation to changing business environments are essential for success.
Empower your team to surpass their KPIs and save precious time by integrating comprehensive accounts receivable automation. By implementing software like Constant, you can efficiently manage routine and repetitive tasks, freeing your team to engage in customer interactions, address disputes, and concentrate on higher-priority responsibilities.
