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How to analyze the effectiveness of debt collection and the status of receivables?

6 min read

Corporate liquidity is a prerequisite for an organization’s survival in the market. A seemingly obvious statement, known to every entrepreneur, and yet it is only in recent years, including the outbreak of the pandemic, that many organizations (especially those that do not remember previous economic downturns) have recognized the true importance of its significance. Monitoring the status of receivables and effective debt collection have begun to play an important role in maintaining liquidity, determining the existence of a given enterprise.

How to take care of liquidity in an organization?

The concept of financial liquidity is associated with the ability to pay financial obligations – invoices, taxes, employee salaries – on time, while making ongoing settlements with contractors related to the business. Maintaining financial liquidity, and thus ensuring that at the end of the fiscal year there are no zeros in the account alone, is the starting base for further investment plans and company development.

“Cash is king” says a well-known saying. Sudden cost-cutting or a drastic reduction in the number of full-time employees, which we see especially during periods of economic turmoil, seem to be solutions for a while. Uncertain times are causing companies to pay more and more attention to liquidity management – an effective solution with long-term results.

According to a survey conducted by the National Debt Register, as many as 60% of companies experience late payments from their customers. How to prevent this? How to reduce the scale of debt in a company?

Often companies focus on large unit amounts of receivables, thus downplaying arrears for smaller amounts, which, however, can like a snowball accumulate their total value and hit the economic efficiency of the entire organization, and in the worst case even threaten the financial health of the company. This is especially true when the company offers solutions, goods, products of relatively low unit value, with deferred payment.

Where to start in the accounts receivable management process?

The accounts receivable management process should begin at the stage of constructing the company’s sales and collection strategy. It is at this stage that the company should anticipate opportunities and threats to on-time payment of receivables and set KPIs, as well as the best payment terms achievable in a specific market; answering questions such as who the customers will be, what their statistical capacity to take out trade credit is, or what the risks of operating in the industry may be. Fine-tuning and negotiating appropriate business terms with customers, including introducing benefits to counterparties for paying their obligations to the company on time, is only a prelude to the next step. The next step is to adjust debt collection procedures, tools used, methods. There are many debt collection techniques, while in this article we would like to focus on monitoring the effectiveness of the procedures used.

How to measure the effectiveness of debt collection?

Monitoring the parameters related to the management of receivables allows the organization to assess the effectiveness of debt collection activities and possibly modify the adopted strategy or procedures in this regard. This is because it may turn out that the established procedure with regard to certain receivables is not always profitable. In other words, the amount of work and costs may exceed the value of the recovered receivables. Before embarking on more serious debt collection activities, it is worth checking the average amount of costs per debt collected, using the adopted procedure.

There are many methods for analyzing the status and structure of receivables. Below are some of them.

Days Sales Outstanding

Useful in assessing an organization’s ability to receive receivables in a given period is the Days Sales Outstanding (DSO), or accounts receivable payment cycle indicator. It helps determine the average time it takes for contractors to pay their receivables in days. In other words – on average, after how many days after an invoice is issued the company receives payment.

It is calculated based on the formula:

DSO = (Average balance of receivables / Sales revenue) x Number of days of the period under review

Let’s illustrate this with an example: We want to assess the ability of company XYZ to receive payments in one month (30 days). Realized sales in the month amounted to PLN 100,000, and the average balance of receivables in this period was PLN 70,000. Then DSO = 70,000/100,000 * 30 = 21. This means that the average time to return receivables is 21 days. 

There is no single optimal range of this indicator for all industries. It depends on the specifics of the sector and the company. It is worth constantly monitoring how this indicator changes in relation to the past, as well as how it looks against the competition.

Why is it so important? The information we get from the calculations allows us to develop more accurate cash flow forecasts for the future; making it easier to manage cash flow, and also allows us to decide whether to change collection procedures or contractual terms with contractors. Often, it is even necessary to modify the company’s business model.

Also important is the correlation of the aforementioned DSO with DPO, the accounts payable coverage cycle ratio. Obviously, the most favorable situation for the company is when DSO takes a lower value of DPO, which in practice means a shorter time to obtain receivables and a longer time to pay liabilities. This leads to a positive effect on the total cash conversion cycle. The opposite situation, on the other hand, leads to unfavorable situations and, as a further result, the need to borrow from other external institutions. In addition, a DSO that is too high can contribute to reduced credibility in the market and problems in obtaining financing or new suppliers.

Receivables turnover ratio

Inverting the above ratio, we can get the receivables turnover ratio. It informs about the efficiency of collecting receivables and is expressed in a multiplier. It answers the question: how many times during the year receivables are transformed into cash.

Receivables turnover ratio = sales revenue / average level of receivables

Of course, the higher the level of the indicator value, the better. It is assumed that the optimal value of the indicator should be in the range <7;10> .If a company obtains an indicator of less than 7 it means that it probably “credits” its customers for too long, while if above 10 the organization probably gives too short trade credit.

However, like the accounts receivable cycle indicator, it is an industry-differentiated indicator, i.e. the level of the indicator should be compared with respect to the range pertaining to the industry and competitors.

Receivables turnover ratio

An accounts receivable aging report can also be a starting point for accounts receivable analysis. It should show all trade receivables with details of past due dates in specific time intervals, along with an indication of the customers in each interval and the amounts past due. The time categories can be individually adopted by the organization, for example, they can look like the following:

  • current receivables (which are not yet past due),
  • receivables past due up to 30 days,
  • receivables past due 30 to 60 days,
  • receivables past due more than 60 days to 90 days,
  • receivables past due more than 90 days to 180 days,
  • receivables past due more than 180 days to 360 days,
  • receivables past due more than 360 days.

The analysis of the report on the aging of receivables and how their structure changes over time makes it possible to see in time the possible risk of a threat to the liquidity of the company and to estimate its possible financial consequences, as well as for a reliable and credible valuation of the position of trade receivables in the balance sheet. At the same time, depending on the accounting policy adopted by the company, it is worth noting that receivables overdue by more than 180 days, and in some companies by more than 360 days, may entail write-downs that will negatively affect the company’s financial result in a given fiscal year. Regular analysis of the aging of receivables also helps identify problematic customers.

How can Power BI help you analyze the effectiveness of your collection efforts and the status of your receivables?

The rise in the importance of receivables monitoring and the increasing prevalence of remote working, which continues to this day entirely or in a hybrid model, has shown how important flexible analytical tools, accessible from anywhere, are for effective receivables management. The analytical and reporting tool of the Business Intelligence class, which is a Power BI, can assist your company in monitoring accounts receivable status and collection activities by, among other things:

  • the ability to integrate with external systems (including accounting, CRM, Excel files) and aggregate a large amount of data in one place,
  • collection, processing of data to be reliable and consistent
  • constant access to up-to-date data on the status of receivables, customers,
  • creation of clear, interactive, up-to-date data-based analytical and managerial reports / dashboards with key collection indicators, structures, KPIs in different time frames,
  • create simulations and relate accounts receivable data to broader cash flow analysis
  • data visualization, making it easier to see trends, the scale of deviations from the norm, the shapes of structures,
  • automate the generation of business and collection reports
  • availability and democratization of access to data (for managers, lower level managers) so they can react appropriately and quickly,
  • flexibility – it can be changed and adapted to your needs at any time.

Introducing appropriate analytical tools in the area of debt collection can be one way to improve liquidity. It can also completely change the existing perception of managers and employees and their priorities towards accruing trade credit. Working with reliable data can contribute to more careful and informed decision-making regarding liquidity.

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