In the ever-evolving and competitive business landscape of today, maintaining a healthy cash flow and maximizing profits is critical for the sustained growth and success of any organization.
A key aspect of financial management that plays a significant role in achieving these objectives is accounts receivable (AR) – but not just having them, effectively monitoring and controlling them. This often overlooked aspect of financial management can make a significant difference in your organization's bottom line and long-term stability.
A research study from Xero and Paypal found that 48% of invoices issued by small businesses are paid late. And 52% of businesses are asked for extended payment terms.
While most businesses offer a 28-day credit term to their customers, the average days sales outstanding (DSO) stretches to 67 days. These figures underscore the challenges businesses face when managing their accounts receivable.
In this blog post, we'll dive deep into the importance of key AR metrics and their role in driving smarter business decisions.
Let’s discuss some of the key AR metrics that every finance professional needs to be aware of. Tracking and analyzing these metrics will offer valuable insights into your company's financial health, empowering you to make well-informed business decisions.
The Accounts Receivable Turnover (ART) Ratio is a crucial metric that evaluates how effectively a company manages its credit sales and collections. It measures how often a business can turn its accounts receivable into cash during a specific period, typically over a year.
The formula to calculate the ART Ratio is:
Accounts Receivable Turnover Ratio = Net Credit Sales / Average Accounts Receivable
Net Credit Sales refers to the total sales on credit less any returns or allowances, while Average Accounts Receivable is the average of the beginning and ending accounts receivable.
Remember that the goal is to achieve a higher ART ratio, as it means that your company can quickly collect payment after a credit sale, keeping cash flowing smoothly.
A lower ratio, on the other hand, could indicate that the company is struggling with collection efforts, potentially affecting its liquidity and ability to meet short-term obligations.
The Expected Cash Collections metric allows a company to forecast effectively the amount of cash it will have at a given time by predicting how much of its receivables it can confidently expect to collect.
The Expected Cash Collections metric can be determined using the formula:
Expected Cash Collections = Cash Sales + Projected Collections from Accounts Receivable.
This calculation can help businesses better understand their current cash position and preemptively avoid potential shortfalls.
Cash Sales refer to the proportion of sales made where customers pay immediately rather than on credit. The rest of the collections come from Accounts Receivable, which includes payments owed by individuals or other businesses that are either current or past-due.
The cash collections from accounts receivable are calculated by first deducting any uncollectible receivables and then estimating the typical collection rates for each aging bucket of receivables (30 days, 30-60 days, 60-90 days, and over 90 days).
This total, along with cash sales, gives the total expected cash collections. Improving the collection process, often through automation, can help increase the effectiveness of accounts receivable management.
The Average Collection Period (ACP) metric in accounts receivable management represents the average number of days it takes for a business to collect payments from its customers after a credit sale has been made.
The shorter the average collection period, the better, as it indicates that the company's credit policies are effective and that cash tied up in accounts receivable is converted back into liquid assets more quickly, thereby improving cash flow.
A longer average collection period may suggest inefficiencies in the company's credit and collections process, potentially indicating a need for improvement in those areas.
The calculation is as follows:
Average Collection Period = (Average Accounts Receivable / Net Credit Sales) x 365
Monitoring this metric over time can provide valuable insights into the effectiveness of a company's credit and collections strategies and its cash flow management.
However, it is essential to acknowledge that what constitutes an "acceptable" average collection period can vary depending on the industry and the specific credit terms the company extends to its customers.
Explore our detailed blog post on "How Does Accounts Receivable Affect Cash Flow?" to gain in-depth insights into the connection between accounts receivable and cash flow.
Days Sales Outstanding (DSO) measures the average number of days it takes a company to collect payment after a sale has been made. In simple terms, DSO indicates the efficiency of a business’s collection process.
To calculate DSO, you use the following formula:
DSO = (Accounts Receivable / Total Credit Sales) * Number of Days
Similar to the Average Collection Period, a lower DSO is typically more beneficial as it indicates that a company is able to quickly convert credit sales into cash, thereby improving its cash flow.
However, DSO can vary significantly from industry to industry, and even among businesses within the same industry, due to differences in credit terms and collection efficiency.
Improving DSO is often a priority for businesses looking to enhance their cash flow and financial performance.
For a comprehensive understanding of strategies to reduce the Days Sales Outstanding (DSO), check out our blog post on 5 Strategies to Reduce Days Sales Outstanding (DSO) in 2023 to gain practical insights.
The Collection Effectiveness Index (CEI) metric provides a more comprehensive view of how effective a company's collection efforts are over a specific period. It helps businesses gauge the success of their collections processes and identify areas for improvement.
CEI can be calculated using the following formula:
CEI = [(Beginning Receivables + Monthly Credit Sales - Ending Total Receivables) / (Beginning Receivables + Monthly Credit Sales - Ending Current Receivables)] * 100.
The CEI is expressed as a percentage, and a higher percentage signifies a more efficient collection process. Essentially, a higher CEI indicates that a company is successful in collecting the money owed to them within a given time frame.
The CEI metric considers both current and overdue invoices, providing a comprehensive view of your collection activities.
Regularly tracking and analyzing the CEI can enable businesses to identify potential issues in the collection process and helps to address issues promptly, and develop strategies to improve your collection effectiveness.
Average Days Delinquent (ADD) is another crucial accounts receivable metric that measures the average number of days invoices remain unpaid after the due date. It helps companies gauge the effectiveness of their credit and collections policy and serves as a key indicator of the efficiency of the collections process.
To calculate ADD, you need to subtract the standard payment terms (usually 30 days) from the Days Sales Outstanding (DSO). The formula is as follows:
ADD = DSO - Standard Payment Terms.
For instance, if your DSO is 45 days and your standard terms of payment are 30 days, your ADD would be 15 days. This means that, on average, your customers are 15 days late on their payments beyond your standard terms.
If the Average Days Delinquent is high, it indicates that customers are taking a longer time to pay their invoices, which can negatively impact the company's cash flow.
To reduce the ADD, a company may need to reassess its credit policies, improve its collections processes, or even consider changing its terms of trade.
Monitoring the ADD metric allows businesses to stay on top of their accounts receivable and ensure they are taking all necessary steps to maintain a healthy cash flow.
The Number of Revised Invoices is a metric that reveals the frequency at which your company has to revise its issued invoices. This accounts receivable metric is crucial as it provides insight into the accuracy of your company's billing procedures and the effectiveness of your credit control procedures.
In an ideal scenario, the Number of Revised Invoices would be low, indicating a high degree of accuracy in the initial invoicing process. High numbers suggest there may be errors or misunderstandings in the initial invoicing stage.
To calculate this metric, you simply count the number of invoices that had to be revised within a given period. For example, if 10 out of 100 invoices had to be revised in a month, then the Number of Revised Invoices would be 10 for that month.
Improving this metric involves tightening up invoicing procedures, enhancing communication with clients, and possibly investing in automated invoicing systems that reduce the likelihood of errors.
Keeping track of the Number of Revised Invoices is a proactive way to identify potential issues in your invoicing process, allowing for corrective action to be taken before these issues impact your cash flow.
Automation is reshaping how businesses operate, particularly in the financial domain, where precision and timeliness are paramount.
Keeping tabs on AR metrics manually can be daunting for large businesses with high volumes of transactions.
It's also susceptible to human errors, which can have significant repercussions on the business's financial health. That's where automation steps in, turning complex calculations and tracking into an effortless process.
Workflows are a solution to automate repetitive efforts, driving real-time visibility into transactions and fostering a more collaborative finance function.
For instance, Constant, a financial process automation tool, enables you to create automated workflows for each application in the finance tech stack. Users can create new workflows or activate pre-built flows to automate manual efforts.
To illustrate, whenever a customer pays an invoice, the Accounts Executive (AE) and the finance operations team get notified automatically via email or Slack. This eradicates the need for manual tracking and reduces the possibility of missed scenarios, making the finance function more efficient and collaborative.
Financial dashboards provide an efficient way to visualize AR metrics. By automating these dashboards, finance teams can monitor real-time metrics and quickly identify trends or issues. Automated dashboards can also consolidate data from various sources, presenting an integrated view of AR metrics.
Constant's dashboards empower finance teams to measure their performance on different aspects and provide a clear overview of their operations.
With dedicated dashboards for teams like Account Payable, Account Receivable, Workflow, and Recon, every team within the finance function can measure the key performance indicators in one single dashboard.
This feature comes in handy, enabling finance teams to monitor, analyze, and make data-driven decisions effectively.
Contract management can often be a time-consuming process. In most organizations, when a new customer signs up and makes the first payment, they sign a Service Level Agreement (SLA), which consolidates every detail of the contract.
The finance teams manually extract and store the important attributes from this contract in a database for future reference.
Constant transforms this process by enabling users to define the list of attributes to be extracted from the SLA. These attributes are then automatically extracted and stored in a searchable form for easy access. Also, Constant provides contract insights like a contract end date and renewal alerts, streamlining contract management further.
Documenting business activities and processes can be challenging. However, automated tools can help represent these processes in a visual format, simplifying understanding and review.
Constant, for instance, provides this capability, making it easier for team members and leaders to visualize and understand the entire financial operations process.
The workbench feature in Constant helps to streamline tasks for the Accounts Payable (AP) team by organizing different views for open, approved, paid and rejected invoices.
It provides a quick view for the approver to approve or reject invoices and for the invoice owner to see all the invoices that have been approved and need to be paid.
In conclusion, Constant’s financial operations automation platform significantly simplifies tracking AR metrics and automates manual, time-consuming tasks.
Constant provides an integrated, efficient, and automated approach to finance operations, helping businesses focus on making data-driven decisions. By leveraging automation with Constant, businesses can transform their finance function into a streamlined, collaborative, and compliant operation.
