Accounts receivable is so vital to a company’s operations that it should be monitored and improved constantly. One way to do that is to track the appropriate KPIs.
By monitoring these AR KPIs, you will see areas in the performance of your company’s AR process that should be improved. Consistent evaluation and improvement of a company’s AR result in higher cash flow and less debt.
There are so many accounts receivable metrics, and all of them play a role in the success of your AR team, but we’ll be discussing five of the most essential of them.
We’ll explain what they are, their impact on AR, and how to calculate them.
Table of Contents
1. Accounts Receivable Turnover Rate (ART)
Accounts receivable turnover rate is a ratio that shows how effective your credit extension and collection solutions are. In simple terms, ART measures the ratio of clients that pay to those that don’t.
A high accounts receivable rate indicates an effective credit and collection process, which translates to higher liquidity for your company.
ART can be calculated by taking the net credit sales and dividing it by the average accounts receivables.
ART = Net Credit Sales ÷ Average accounts receivables
So, if your company’s net sales in a year is £20,000,000, and average receivables is £3,000,000. The ART ratio would be 6.7 ART. This high value indicates a healthy cash flow and better access to operational capital.
The ART value is also indicative of a few other things, such as the company’s credit policy, employee productivity, and the risk levels of its customers.
2. Day Sales Outstanding (DSO) and Best Possible Days Sales Outstanding
The Days Sales Outstanding is a metric that tracks how long it takes customers to pay.
DSO is one of the most essential AR key performance indicators to track because it directly shows how effective your AR collection solution is. It’s also a good metric to show investors that your firm is liquid and operational from generated revenue.
The formula for calculating the days sales outstanding is as follows:
DSO = (Total Accounts Receivables ÷ Total Credit Sales) × Number of Days
The ideal DSO value should be low to indicate that your company is collecting payments as early as possible. This means increased cash flow for company operational costs. In an ideal situation, your company’s DSO should not exceed the credit agreement by 50%. If the payment agreement is for 40 days, your DSO shouldn’t exceed 60 days.
Higher DSO values don’t just indicate a poor AR process; they aren’t also profitable for companies. They could also be a sign of flawed credit agreements that give customers too long to pay. When tracking your company’s DSO, keep in mind that a healthy range depends on the industry’s credit terms.
As insightful as the DSO is, the best possible days sales outstanding is a stronger KPI.
The best possible days outstanding KPI shows the best possible payment turnaround you could get based on your AR process. For a company that is doing perfect, its DSO should match its best possible DSO. Unfortunately, there is hardly any ideal situation in AR, and the best companies can hope for is a close gap.
The formula for calculating the best possible DSO varies slightly from the formula used to calculate DSO.
Best Possible DSO = (Current Accounts Receivable ÷ Gross Revenues over period) × Total Number of Days
Between the two DSO, the best possible DSO gives a more concise insight into the effectiveness of AR collection processes. Companies can use the data obtained from this KPI to improve their collection processes.
3. Collections Effectiveness Index (CEI)
While the ART rate measures how quickly your customers pay, the collections Effectiveness Index measures how fast your team collects payment within the allotted time.
The accounts receivables team is made up of two arms
- The owing customers;
- The collection department.
The former is usually the problem part of the AR equation, but the collection department is also important. Collection solutions, strategies, and procedures affect the rate at which customers pay.
The formula for calculating the Collections Effectiveness Index is as follows:
CEI = ((Beginning AR + Monthly Credit Sales – Ending Total AR) ÷ (All Beginning Receivables + Monthly Credit Sales – Ending Current Receivables)) × 100
Note that how effective your AR team is, depends on how low the value of this index is. In other words, the higher the index, the less effective your team is at closing invoices.
4. Average Days Delinquent (ADD)
Average Days Delinquent is simply a metric that tracks how late customers are in paying for their services.
The formula for ADD is as follows:
ADD = Regular DSO – Best Possible DSO.
ADD helps you know when and how much pressure to mount during the collection phase to avoid a high bad debt-to-sales ratio. It also makes your AR team efficient in closing invoices.
5. Bad Debts to Sales Ratio
One of the vital account receivable metrics is the bad debt-to-sales ratio. No matter how much a company wishes it, not every customer would pay for services rendered. These unpaid invoices are known as bad debt. The goal of every company is to keep their number of bad debts to the lowest minimum. In place of that, however, companies strive to keep the ratio of bad debts to the barest minimum.
To calculate this ratio, use the formula below:
(Uncollected Sales ÷ Annual Sales) × 100
Say your company’s total annual sales for the year is £35 million, and you struggle with a bad debt of £15M, your bad debts to sales ratio would be 43%.
Any value above 15% means you have an excellent bad debt-to-sales ratio. Any value above 15% is negative.
Companies with great accounts receivable teams try to keep this number low to reduce company loss.
If your bad debt-to-sales ratio is very high, evaluate the collection policies and strategies used by your AR team.
Conclusion
Tracking essential KPIs is an important practice that helps companies and organizations assess their performance and make the necessary improvements.
It’s crucial to access and track major AR metrics because it affects the company’s cash flow.
