Cash flow is king

by Abe WalkingBear Sanchez

In many businesses, one of the biggest assets, if not the biggest, is accounts receivable (A/R). Next to cash on hand, your A/R is probably the closest thing to money in the bank.

The time it takes for A/R to turn around and be collected is important for accurate cash flow projections, and also as a way of measuring what kind of job is being done managing A/R. Knowing these measurements isn’t always easy.

When credit is extended, an A/R is created which sits on the right side of the balance sheet with other assets. While an accepted business practice, it can be difficult to track how quickly these payments are made. Days Sales Outstanding (DSO) is often used to measure A/R turn time, but it does have some failings.

Using DSO to compute turn time is like taking a census. When sales increase and new A/Rs are added, it’s like a population boom; the average age, or DSO, goes down. A drop in sales means fewer new, young A/Rs are being added, and the average age and DSO go up.

The failing of DSO is that it’s an after-the-fact measurement, and we can’t change history. At least not yet.

A simpler and more accurate formula for computing the turn time on A/R provides ongoing, real-time feedback on collections. Collection Days Index (CDI) is equal to the terms of sale divided by the end-of-month collection percentage.

Here’s how it works
Step one. Start with the total beginning A/R balance as of the first of the month. This means all A/Rs regardless of age. (Any new credit sales made during the month will be picked up in the next month’s beginning total A/R balance.) For example, say our  total A/R balance as of the first of the month is $1,000.

Step two. Track collections on those invoices that make up the beginning total A/R balance. During key times of the month (the 10th and the 20th), compute the collection percentage as of that date by dividing the amount collected by the beginning total A/R balance.

If by the 10th, for example, we have collected $200 of the beginning $1,000 total balance, our collection percentage is 20 percent as of that date.

We can compare this month’s 10th day collection percentage against last month. If the percentage last month was higher, it doesn’t necessarily mean we’re doing a poorer job. Less a matter of good or bad, it’s more about “why?”

A lower collection percentage may be the result of the A/R person being out on vacation with no one following up on past due A/Rs. It may be a matter of a product or service with a lower product value being sold to someone with less-than-perfect pay record performance.

If we’ve collected $400 of our $1,000 due by the 20th, our collection percentage as of that date is 40 percent. By tracking the collection percentage during the month, we can determine whether we need a greater effort. It’s like a sales guy who is way behind his sales quota by the third week of the month. He has a week to turn the month around.

Step three. At the end of the month, compute the CDI by dividing the collection percentage into the terms of sale.

Assume that at the end of the month we’ve collected $500 of our beginning A/R total of $1,000. Our collection percentage is 50 percent. If we’re selling on 30-day terms, our CDI would be 60 days.

If you have varying terms of sale, you must compute the CDI for each and then take the average, just as you would do with the DSO.

There are numerous advantages of using CDI over DSO. It results in a more accurate, real-time measurement of A/R turn time. It also provides a way to track collections during the month. And, it enables you to know if corrective action must be taken to turn the month around.

At home or on the job, it’s important to know when your money comes in.

Abe WalkingBear Sanchez is an International speaker/trainer on the subject of cash flow/sales enhancement and business  knowledge organization and use. Copyright 2002 A/R Management Group Inc. www.armg-usa.com  All Rights Reserved.

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