Relying on DSO or Aging Payables Could Cost You

Days Sales Outstanding and Aging Payables are the only two measures tracked by most AR leaders, according to a recent survey by IOFM. But they can also be among the most misleading.

The formulas are simple:

DSO: Receivables divided by total credit sales, multiplied by number of days in that period. It gives you an average of how long it takes to get paid.

Aging Payables: Share of collections in aging groupings, typically: Current, <30 days, 30-60 days, 61-90 days, >90 days.

But they can be too simple.

In today’s economy, the reason for closely tracking your receivables is to know which customers are paying later than they normally do. A company that used to take early pay discounts and is now paying at the end of their 30-day terms wouldn’t show up in your DSO or aging payables report, because technically they are still paying on time. But paying later than they normally do should be sending off red flags.

How DSO Can Misinform

DSO Averages Mask Details

In your DSO calculations, every company that pays early is covering up for one paying late. It comes out as a wash in your DSO and can be deceptive.

DSO Doesn’t Account for Payment Terms

If your sales team were to close a large sale, the size of credit sales in that period would spike – leading to a numerical improvement in DSO even though AR hasn’t collected any cash. On the flip side, a dip in sales would show a worsening DSO that isn’t AR’s fault.

Similarly, aging payables can give you a false reading on the state of your receivables.

Why Aging Payable Can Misinform

Any challenge to the invoice can mean that a sale isn’t collectable yet and therefore not tracked on “aging payables”. And because IOFM believes disputes are on the rise as customers flood AR as a means by AP to delay payment, this can easily water down any real issues with your aging.

In addition, aging payables can conceal individual payment data. If a customer always pays 15 days late, another “late” payment shouldn’t be treated the same as an on-time payer who is now running late. But the alarm is the same.

Five Other Measures to Consider

You should continue to track DSO and Aging payables but must be aware of their shortcomings. Look for complimentary measures that can give you a more complete picture.

Consider Subtracting DSO from Best Possible DSO (current AR divided by total credit sales and then multiplied by the number of days in that period). That’ll help you track just how efficient your team really is.

Collective Effectiveness Index (beginning receivables minus ending current receivables, divided by the beginning receivables minus ending total receivables; and then multiplied by 100 to get a percentage). CEI supplements your aging payable analysis by showing how well you are at enforcing payment terms.

AR Turnover Ratio (new credit sales divided by average AR) can tell you how many times per year receivables are collected and therefore how liquid your organization is.

Share of Current AR can help identify what share of your receivables are still within terms.

Bad Debt to Sales Ratio can illustrate how much potential cash you’re writing off.

Don’t Stop There

Once you have a set of core measures you trust (note: data quality is crucial), drill down all the way to the individual AR clerk. The goal is to identify who is doing the best job (most efficient and most effective) so you can capture lessons learned and share those with the rest of the analysts. (Don’t make this punitive to bottom performers.)

This is not a time you can afford not to know your numbers. The economy is too uncertain to rely on the old stand-by metrics that only give you a partial picture of your AR.