As the CFO of a Los Angeles-based shipper/distributor who did not want to be identified puts it, “When metrics reflect something different than expectations, any anomalies must be investigated. If the anomalies reveal something significant, then the credit criteria must be examined for that particular customer. Perhaps a discussion with the customer may reveal a temporary situation or extenuating circumstances.”
Not every company is in a position to sell only to top paying customers throughout the industry. Often, growth and increased sales are a result of assuming increased credit risk. In these situations, using a metric to monitor those accounts can be beneficial. One such ratio is the ‘prior month’s past due collected’ ratio. The formula, current month’s past due age categories divided by the beginning receivables of the prior month will show you what has been collected this month on the past due amount. While this could be self-evident in this month’s A/R aging report, it doesn’t help you monitor your collection efforts.
Another way to evaluate effectiveness is to analyze the cost of the resources devoted to collections versus sales. The following relationship is similar to determining an organization’s “cost per employee,” but specifically shows the dollars spent in efforts to collect each dollar of credit sales. The formula is as follows (the higher the percentage, the better): department/credit personnel costs divided by credit sales.
Another straightforward tool used to determine credit department effectiveness is a review of the two most dreaded words for any business—bad debt. A simple calculation can reveal the accuracy of credit decisions relative to overall credit sales. This is found by taking bad debt, net of recoveries, then dividing by credit sales. The lower the percentage of dollars written off to sales dollars, the better!
Choosing the Right Measurement(s)
Unfortunately, there is no one universal metric that every organization should use. Rather, you should consider whichever formula will help you understand your accounts, monitor their performance, and serve as a reliable guidepost for your collecting efforts.
According to Vaiz, every company should have “their own credit policy and philosophy in how they approach credit and collections.” Further, he explains, “the metric used should coincide with that policy and philosophy, and should convey whether credit is being managed according to it.” While Vaiz confirms there is no single magic number, he supports the use of metrics by emphasizing again, “You can’t improve what you can’t measure.”
Brown finds DSO a useful tool because “it helps communicate and explain to everyone within the organization how well the company is collecting its money, which provides a better framework for making management decisions.”
Brown referred to DSO as a precursor to ensuring a company’s ability to be financially flexible. At Hapco, he says, “If we encounter a situation where our sales manager is requested by one of our retailers to provide more products, our DSO can provide a snapshot of our own ability to pay more suppliers within their terms.” To explain further, he uses the following as an example: “If our DSO shows an average of 23 days and a supplier expects payment within 30 days, we know we have the financial flexibility to accommodate the additional sales.”
The right “blend” of measurements and metrics will be different for each company; yet metrics can be a valuable internal tool for businesses of all types and sizes to both communicate and monitor the effectiveness of collection policies and processes.
