KPI Series: Collection Period

 

What do we mean by “Collection Period”?

 

Collection Period is a measure of how long it takes you to collect your money after you make a sale.  Its unit of measure is “Days”.  If your Collection Period is 45 days, this means that on average it takes you 45 days to collect the money from the time you make a sale and send out the invoice. 

 

Why does it matter?

 

Collection Period matters a whole lot because it can have such a huge impact on how much cash you need to run your business.  Take a business doing $1 million in annual revenue.  The difference in cash tied up with a collection period of 60 days vs. 30 days is more than $83,000.  So it is important to monitor this key measure, and keep it as low as possible.

 

What types of business it is appropriate for?

 

Any business that extends credit to customers should use this measure.  This would include service businesses and manufacturers.  But probably not restaurants or retailers who sell primarily for cash or credit cards.

 

How it is calculated

 

It’s straightforward in concept, but a little messy when you delve into the details.  One method you could use would be to take each invoice sent out during the last year, and calculate the number of days it took until payment was received.  Add these up, and divide by the number of invoices to get an average.

 

But you run into a couple of problems.  What about the invoices that are still outstanding?  Those would not be included in the calculation, and the resulting calculation would understate your true collection period.  Then there is the not so trivial problem of getting the data in a form that allows you to do the calculation.  There could be lots of manual input involved – i.e.  a sure fire recipe for not getting it done.

 

An alternative is to calculate the number of Days of Sales Outstanding in Accounts Receivable (DSO – A/R), and use this as an approximation for Collection Period.  The way you calculate “DSO – A/R” is that you take your end of month A/R Balance, and divide by Daily Sales to convert the A/R Balance to a number of days.

 

Sample Collection Period calculation

 

If you average $30,000 a month in sales ($1,000 per day), and your A/R Balance is $30,000, then your “DSO – A/R” is $30,000 / $1,000 or 30 days. 

 

If your A/R Balance is $60,000, then your “DSO – A/R” is $60,000 / $1,000 or 60 days. 

 

When you think about it, it makes sense:  if it takes 60 days on average to collect the money, then at the end of two months of selling $30,000 a month – from a standing start – you would have built up an Accounts Receivable balance of $60,000.  Each month after that, you would collect $30,000 from the 2nd prior month, and make another $30,000 in sales, so that your Accounts Receivable balance would stay at a constant $60,000.

 

Of course, neither Sales nor Accounts Receivable stay constant.  The trick is to choose a time period over which to calculate Daily Sales.  One month is too short, and a year too long – I favor a three month time period.  Then you can calculate the “DSO – A/R” each month by taking the A/R Balance and dividing by the last three months worth of Sales, converted to a Daily Sales rate by dividing by 90.

 

Excel

 

Assume monthly values are in columns B, C, D, etc.  You can calculate “DSO – A/R” starting in column D:

 

1 Sales

2 Accounts Receivable

3 DSO A/R  in column D = D2/((B1+C1+D1)/90)

            in column E = E2/((C1+D1+E1)/90)

 

 

SurvivalWare

 

Go to the Performance Metrics Tab.  Scroll down to the “Drivers of Working Capital” section.  “Days of Sales in A/R” is the line to look at.

 

 

Learn more about how companies use Survivalware to monitor their KPI’s at www.survivalware.com/case_studies.html

 

Tips on minimizing your collection period

You have to be careful, because extending credit to your customers can be a way to attract and retain loyal customers.  So you have to strike a balance between fast collections and lost sales.  So to the extent you can without losing customers, try the following:

·         Sell for cash only

·         Offer to take credit cards

·         Offer early payment discounts (e.g. 2% if paid within 10 days)

·         Extend credit terms very selectively

·         Have someone call for collection one day after the bill is due if it hasn’t been paid

·         Send out customer statements and overdue notices religiously to

·         Negotiate contracts to include up front and progress payments instead of getting paid just at the end of the job

 

 

Please leave comments for techniques that have worked for you.