Performance Measures for Credit, Collections and Accounts Receivable

CRF thanks Rob Olsen, CCE for his work on this section

If there is one thing that credit executives agree upon, it is that they cannot agree on which measures to use in evaluating individual, departmental, and company performance. In researching the myriad measures available, it is evident that choosing an individual or group of measures is a personal, company, or industry preference. Since many organizations cannot agree among themselves on which measures to use, the person with the most authority usually dictates the measures to be reported to management. Even though credit, collections, and accounts receivable personnel report the requested data to management, most individually track other measures to "see how they are really doing."

This section is not attempting to dictate, or even suggest, which performance measures are most valid and should be used. The purpose of this section is to serve as a reference guide to readers and provide them with a comprehensive collection of performance measures used in credit, collections, and accounts receivable, hence, allowing the individual to make educated decisions on what to use and why.

Dynamic credit executives plan and direct the credit, collection, and accounts receivable functions to increase sales and profits. While pursuing these goals, they use their decision-making capabilities to foster growth, optimize cash inflows, and improve the quality of work performed by credit, collections, and accounts receivable personnel. Using valid measures of performance is critical in this process. For many years credit and finance professionals, along with academic researchers, have been seeking a means of accurately measuring performance in credit, collections, and accounts receivable. Most of the measures that are currently in use have value. Unfortunately, they also have flaws. The challenge is to understand the individual measures and use them appropriately. The prudent credit professional will have a clear understanding of the importance of spending the necessary time and effort to understand the individual measures of performance and implement the appropriate measures to meet the needs of their organization.

Using Appropriate Measures of Performance Can Help:
Identify areas of expertise Identify areas of potential growth
Improve policies and procedures Reduce errors or defects
Shorten lead time Increase customer satisfaction
Reduce customer complaints Increase customer retention
Improve financial performance Improve employee morale
Focus employee training and support Increase productivity
Increase cash flow Reduce costs
Reduce bad debt Perform fair individual and group evaluations

Regardless of the measures chosen to evaluate an organization, they must be able to stand the test of time. The measures that make an organization look good today may not in the future. The goal is to identify and consistently use valid measures that work over time, not just measures that work for the moment.

If a measure is not understood it should not be used. It is difficult to explain or defend something that is not understood. Always use measures that accurately reflect reality, and then manage for improvement.

What Makes A Measure Meaningful?
A meaningful measure fills a need and meets a specific objective. If a measure does not accomplish a purpose, don't use it. If a measure is being used and the objective is not understood, figure it out. All productive activity has a purpose. Meaningful measures will support the organization's mission and help reach organizational goals.

The measure used must have a standard. The standard can be a set value or a range. For example, if the controller of a company is using Days Sales Outstanding (DSO) as an overall measure of accounts receivable in relationship to credit sales, what is acceptable? Is the standard a set value such as 45 days, where any value below 45 days is acceptable? Perhaps the standard is a range such as 42 days to 51 days, where any value within the range is acceptable. Using a range as a standard has some benefits. In this example, the low-end of the range may reflect a credit policy that is too strict, while the high end may indicate a policy that is too liberal. If a company does not sell to marginal customers, the company's DSO will be lower than if they accept the increased risk and potential profit associated with marginal customers.

A measure must be compared to some standard or it has no meaning. Standards may be set according to past organizational or industry values or trends. Again, using the DSO example, the acceptable range may be the industry high and low from a standard determined externally, such as those published by the Credit Research Foundation in its quarterly publication, The National Summary of Domestic Trade Receivables or Robert Morris Associates' Annual Statement Studies. Choosing a range for a standard can provide the tolerance that is sometimes needed to allow for situations such as seasonal sales.

Consistency is the next element of a meaningful measure. If the standard DSO calculation is used one month, Sales Weighted DSO cannot be used the following month. Likewise, the acceptable standard and the comparable standard cannot change monthly. It's true that measures need to be evaluated and updated from time to time, but the update should be completed on more of an annual basis than monthly.

The effective implementation of measures requires action. This is similar to a guidance system on a missile. It has an acceptable standard (hitting the target). It also has a comparative standard (the course to the target). The missile is constantly comparing its current position (course) to its destination (target) and making the necessary corrections to stay on course. As mentioned earlier, the acceptable standard can be specific or general.

An effective measure provides a benefit. One benefit could be the satisfaction of reaching a goal and realizing the implications of that success. The question could be asked, "If a measure provides no benefit, why bother using it?"

Organizations should communicate all measures and standards to those individuals who are responsible for executing the action plan that will help the organization reach its goals. Measures of performance should be graphed or charted as part of the reporting process. The old adage that states, "when performance is measured, performance improves, but when performance is measured and reported, the rate of performance accelerates" is true.

What Is The "Right" Measure?
The right measure is the one that meets your organizational needs. To determine if a measure meets your organizational needs, logic dictates that you must first understand those needs. Once your needs are understood, you must then identify the most appropriate measure to meet them. This requires a thorough understanding of what the measure expresses. The right measure will express a value that complements and supports the objectives of the company, division, department, or subgroup.

The following questions will help you determine if the right measure is being used:

TIP
When calculating formulas that require the number of employees and an employee performs tasks in addition to the measure being calculated, you must allocate the employee as a percentage of the time spent working on the measure being calculated or the ratio will be inaccurate. Always allocate employees in terms of full-time equivalents.

Formulas such as DSO that use periods of time, can be very erratic over the course of a year if the business is affected by seasonal sales influences or long dating terms. A suggestion would be to change the formula to use a year's worth of data. For instance use a rolling 12 months so that the impact of the sales peaks and valleys is somewhat neutralized.


Credit and Collection Measures

Collection Effectiveness Index (CEI)

Definition: This percentage expresses the effectiveness of collection efforts over time. The closer to 100 percent, the more effective the collection effort. It is a measure of the quality of collection of receivables, not of time.

Formula:

Beginning Receivables + (Credit Sales/N*) - Ending Total Receivables
Beginning Receivables + (Credit Sales/N*) - Ending Current Receivables
X 100
*N = Number of Months or Days


Days Sales Outstanding (DSO)
Definition: This figure expresses the (aggregate) average time, in days, that receivables are outstanding. It helps determine if a change in receivables is due to a change in sales, or to another factor such as a change in selling terms. An analyst might compare the days' sales outstanding with the company's credit terms as an indication of how efficiently the company manages its receivables.

Formula:

Ending Total Receivables x Number of Days in Period Analyzed
Credit Sales for Period Analyzed



Best Possible Days Sales Outstanding or Average Terms Based on Customer Payment Patterns
Definition: This figure expresses the best possible level of receivables.
TIP This measure should be used together with DSO. The closer the overall DSO is to the Average Terms Based on Customer Payment Patterns (Best Possible DSO), the closer the receivables are to the optimal level.

Formula:

Current Receivables x Number of Days in Period Analyzed
Credit Sales for Period Analyzed


Sales Weighted DSO
Definition: This figure expresses the (aggregate) average time, in days, that receivables are outstanding.

Formula:

Note: There are several formulas to calculate Sales Weighted DSO. This is a simple expression of those formulas. Other formulas or expressions yield the same results.


True DSO
Definition: The accurate and actual number of days credit sales are unpaid.

Formula:



Delinquent DSO or Average Days Delinquent
Definition: This figure expresses, in days, the average time from the invoice due date to the paid date, or the average days invoices are past due.

Formula:



Days Average Collection Rate
Definition: This figure expresses, in days, the average time from the invoice date to the date paid.

Formula:

Total Flow of Funds
Total Funds Applied



Prior Month's Past Due Collected
Definition: This percentage expresses the amount that has been collected in the current month of the prior month's past due amount.

Formula:

1 - Current Months Past Due Age Categories
Beginning Receivables of Prior Month


Percent Over 61 Days -- or Percent of Any Age Category
Definition: This figure expresses the percentage of Total Receivables that is 61 Days or more past due.

Formula:

Sum of the 61 Days and Older Categories
Total Receivables



Bad Debt to Sales
Definition: This expresses the percentage of credit sales that were written off to bad debt. A lower percentage signifies that effective credit policies and procedures are employed.

Formula:

Bad Debt Net of Recoveries
Credit Sales



Active Customer Accounts per Credit and Collection Employee
(Total Department)
Definition: This figure represents the total number of active accounts per department employee. Generally, the higher the number of accounts per employee, the more efficient the use of technology and people. (This is a departmental measure.)

Formula:

Number of Active Customer Accounts
Number of Total Department Employees



Active Customer Accounts per Credit Representative or Collector
Definition: This figure represents the total number of active accounts for an individual credit representative or collector. Generally the higher the number of accounts per employee, the more efficient the use of technology and people. (This is an individual measure.)

Formula:

Number of Active Customer Accounts
Number of Total Credit Representatives or Collectors



Operating Cost per Employee
Definition: This figure represents the total dollars spent per employee. The lower the cost, the more effective use of technology and people.
TIP Operating Cost per Employee is listed here in the Credit and Collections section, but is just as valuable and applicable under Accounts Receivable. The formula is the same for each department.

Formula:

Departmental Operating Costs
Number of Department Employees



Cost per Sales Dollar
Definition: This calculation relates dollars spent in the credit and collection effort to credit sales generated, or how much it cost the company to process each dollar in credit sales. A higher percentage signifies that a more effective operation is employed:

Formula:

Departmental Operating Costs
Credit Sales

Is your cost per credit sales dollar good? This question is relative. It could be answered by benchmarking with other organizations or measuring itself against its own past performance.


Cost of Collections
Definition: This percentage represents the cost of collecting the collectable amount of Bad Debt. The lower the percentage, the more effective the attorney(s) or agency(s) employed.

Formula:

Amount Paid to Attornies and Agencies
Collected Amount



High-Funds Accounts
Definition: This measure identifies accounts where significant funds could be collected in a relative short time.

You must set the criteria for your business. Example: by identifying accounts that have at least $2,000 over 60 Days and a total due of $5,000 or more that are not paying according to terms because of improper billing or processing problems. The closer to zero the more effective the collection effort, the better the working relationship with the customer and the more credit, collections, and accounts receivable policies and procedures are being followed.

Formula:

The Number of High-Funds Generating Accounts



High-Risk Accounts
Definition: This measure identifies significant potential bad debt accounts so they can be collected, thereby maximizing profits by minimizing losses.

You must set the criteria for your business. Example: these accounts have at least $2,000 over 60 Days and a total due of $5,000 and the customer is not paying because of its lack of ability to pay or some unknown reason for not paying according to terms. The closer to zero the more effective the collection effort, the better the working relationship with the customer and the more credit, collections, and accounts receivable policies and procedures are being followed.

Formula:

Number of High-Risk Accounts


Accounts Receivable Measures

Check Turnover per Cash Applicator

Definition: This figure indicates the number of checks processed per person responsible for actually applying checks. A higher turnover rate implies that an efficient system is employed.

This measure could include automated remittance processing "auto-cash". (Whether automated processing is included or not is a matter of choice, or in benchmarking comparability, sense consistency is the key.) Once the parameters are set, they should not change in like comparisons.

Formula:

Number of Checks Processed
Number of Cash Applicators



Transaction Turnover per Cash Applicator
Definition: This figure indicates the number of transactions processed per cash applicator. A transaction includes all invoices, credits, deductions, and payments. A higher turnover rate implies that a more efficient system is employed.

This measure could include automated remittance processing "auto-cash". (Whether automated processing is included or not is a matter of choice, or in benchmarking comparability, sense consistency is the key.) Once the parameters are set, they should not change in like comparisons.

Formula:

Number of Transactions Processed
Number of Cash Applicators



Transaction Turnover per Accounts Receivable Employee
Definition: This figure indicates the number of transactions processed per individual employee. All employees involved in accounts receivable are included because their combined duties are directed in some fashion to processing transactions of all types. This includes secretaries, administrators, supervisors, and managers. A transaction includes all invoices, credits, deductions, and payments. A higher turnover rate implies that a more efficient system is employed.

This measure could include automated remittance processing "auto-cash". (Whether automated processing is included or not is a matter of choice, or in benchmarking comparability, sense consistency is the key.) Once the parameters are set, they should not change in like comparisons.

Formula:

Number of Transactions Processed
Number of Accounts Receivable Employees



Deduction Turnover per Cash Applicator and A/R Deduction Specialist
Definition: This figure indicates the total number of deductions processed by cash application and deduction specialists. The higher the turnover, the greater the efficiency per employee. (However, the lower the number of deductions, the more efficient the organization's billing process.)

Formula:

Deductions Processed
Cash Applicators & Deductions Specialist



Operating Cost per Transaction
Definition: This figure indicates the cost of an individual transaction. The lower cost per transaction implies a more efficient use of technology and people.

Formula:

Departmental Operating Costs
Number of Transactions Processed

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