By: Cheryl Pinson, CCE, Regional Credit Officer at Bunge North America, Inc
For years upper management has wanted you to report your DSO. To many, it is the golden measurement of payment collection progress. Management sees it as a measure of how quickly your team is converting the receivables to cash. And it certainly is a measure of that process. However, it can be misleading. Especially if you have managers who just think “bigger DSO is bad, smaller DSO is good” and really do not understand the full story behind this metric. Sometimes an increase in DSO can be good for business or completely out of the control of the collection team.
DSO = Total AR / (Total Sales over XX days / XX days)
DSO, which take your total outstanding AR and divides is by Total Sales over a given period of time, comes up with the average number of days it takes to collect payment. If your DSO is 37, is that good? If it goes from 37 to 39, is that bad? The answer is maybe, maybe not. You see if your payment terms are all net 20, then a DSO of 37 days may not be very good. If your payment terms are all net 45, then a DSO of 37 may be really strong. But most of us have a variety of different payment terms, stretching from prepayment to net 90+, depending on the industry we are in and the make up of our customer base.
Further, we have larger businesses who are coming to us demanding longer payment terms (Anyone? Just me?) While net 30 terms may have been the industry standard in the past, most larger businesses are starting to require net 60, net 90 or even longer if you want to keep the business. You know they are not a cash flow risk or a credit risk but it is going to increase your DSO if you grant one of your largest customer’s longer terms. But you may lose the business if you don’t, and that is probably worse! So, for business reasons more than credit reasons, you agree to extend the longer terms knowing your DSO will go up, even if that customer pays on time with the new, longer terms.
At the next management meeting the Vice Presidents demands to know why your DSO went up three days. Isn’t your team doing its job? You try to explain about the longer payment terms but to managers it just sounds like excuses. So what can you do?
First, educate your managers. Tell them DSO does measure the average number of days it takes to collect payment but it is not does not consider if a dollar is current or past due. The calculation considers Total Receivables and not which aging bucket they fall in. So, if you suddenly have a big jump in sales during a month – which is a great thing to have– your DSO can jump up considerably!
If your DSO is 37, is that good? If it goes from 37 to 39, is that bad? The answer is maybe, and maybe not.
Here is what I mean:
If you have total AR of $1 million and Total Sales over a ninety day period of $3 million, your DSO is 30 days.
If you have a rock star sales guy who gets an extra $500,000 sales this month on net 30 terms, you now have $1.5 million in Total AR and $3.5 million in sales over the same period and your DSO jumps to 38.6! What? More sales hurt me? But we WANT more sales! That is supposed to be a good thing! And it is, but it will alter your DSO. Share this with them to show them how DSO measures more than collection activity, therefore it shouldn’t be used as only a collection activity measurement.
Second, give them better measurements that focus on how well you are collecting on the past due balances. Because that is what collectors do, right? They tend to the dollars that were not paid on time. So let’s measure what they actually do!
DDSO (Days Delinquent Sales Outstanding) measures only the AR balances that are beyond their payment terms. It is the same calculation as DSO but instead of using Total AR you only use the Past Due AR balance.
Keeping with our previous example, let’s say that of that $1 million in Total AR, only $200K is past due. You still use the $3 million in sales over 90 days in your calculation. Now your DDSO is 2 days. Meaning your average past due dollar is collected in two days. Now when that great sales guy makes a new sale of an extra $500,000, your DDSO actually goes down to 1.7 days! So more sales makes a positive impact on your numbers. This is how it should be! Better sales should reflect better on all metrics.
Of course the math works the other way too. If sales were to go down to $2.5 million your DDSO goes up to 2.4 days. Now collections is penalized for bad sales. But, our metrics are all tied together in the company and when sales are down, it makes sense that other metrics are also impacted. This is a bit easier to explain to management – they all understand what a “dip in sales” can mean to the overall business.
Let’s look at a metric that doesn’t consider sales at all. Past Due Percentage, also called “delinquency rate,” ignores sales and strictly focuses on past due balances. Warning….there are no scape goats in this metric, it is all about the performance of the collection department! No blaming Sales or anyone else!
The Past Due Percentage (PDP) simply takes the Total Past Due AR divided by the Total AR balance to give you a percentage. Following this trend month over month can tell you if your team is doing a better job at collecting the past due balances or if they are struggling to collect them.
In this case you want to set a goal of what you think a reasonable PDP would be and then track your actual PDP to that goal. Continuing with our example, if your Past Due AR is $200,000 and your Total AR is $1 million, you have a past due percentage of 20%. If your PDP last month was 22% then you have tightened up your collection efforts and you are pleased with that lower number. If your PDP last month was 18% and you are now and 20% you might be a little concerned and need to do some investigating. Was there one or two big balances that caused the increase? Did your best collector leave the company and you are trying to replace her? What caused an increase in PDP? This gives you an opportunity to really look into your past due balances and see where opportunities for improvement may lie.
Further, if you have specific collectors responsible for specific accounts, you could do a DDSO and PDP metric for each collector to identify your stronger collectors and those who may need more training. You can also use this to give them individual goals to achieve for the yearly Performance Management Plans.
Now, all of this does not mean that DSO is not a useful metric. It certainly can be! But it isn’t a metric that is indicative of only the collection activity. It is a measurement of cash flow also influence by Sales and business decisions to increase payment terms.
If you are still using DSO as your primary measurement of the Collections Department, you are selling yourself and your team short! Start working to educate management that there are better methods to use to measure the effectiveness and productivity of your team.
By: Cheryl Pinson, CCE
Cheryl Pinson, CCE has worked in the Credit and Collections field for more than 20 years working for Brown Shoe Co and GE Capital. She was the Credit Manager at Watlow Electric Manufacturing Co. until 2005, responsible for both domestic and international collections for the company and is also Six Sigma / Greenbelt certified. She is now Regional Credit Officer at Bunge North America, Inc, Cheryl also teaches various courses for the NACM Connect Institute of Credit. She was awarded with the NACM Gateway President’s Award in 2012 for her many contributions to the Association. She also received the National Instructor of the Year Award at Credit Congress in 2015.