In any business it is a usual practice to provide credit to your customers. Granting credit helps the business in increasing sales but at the same time also increases the risk of uncollectible accounts.
The company needs to actively manage and monitor the accounts receivables and evaluate how well the company is managing its receivables. The regular monitoring involves keeping a continuous tab on the outstanding receivables balances, and reporting any deviation from the normal practice. The two important performance measurement reports are Accounts Receivable Aging Schedule and Day’s Sales outstanding.
1. Days of Sales Outstanding (DSO)
Also known as the Average Collection Period, DSO is calculated by dividing Average Accounts Receivables by Average daily sales.
The Days of Sales Outstanding tells us on an average how much time it takes to collect the receivables (Time lag). Following analysis can be made from the calculated ACP. Below are a few important points about DSO.
- Indicates how quickly the receivables are collected.
- A lower DSO indicates that the company is taking lesser time to collect its receivables.
- A high DSO implies poor credit/collect policy.
Example
A firm provides 30 days credit period as per their credit policy. Their DSO for the first three quarters is 60 days, 50 days, and 45 days.
From this data we can say that the company has not been able to collect money as per its credit policy (30 days credit) in all three months. However, the trend of the three months shows that the efforts in collecting funds are improving as the Daily Sales Outstanding are coming down.
This method suffers from two limitations. One is that it aggregates all accounts receivable ignoring individual accounts collection. And the other is, sales keep varying that will not give the accurate picture though based on the average.
2. Accounts Receivables Aging Schedule
This is one of the key reports used by the accounts receivables managers. The report provides a breakdown of the accounts receivables based on the days outstanding. This breakdown helps the firm in organizing its collection efforts. For example, the accounts that are outstanding for a longer period will need to be collected on priority. The standard breakdown for accounts receivables is ‘<30 days due’, ’31-60 days due’, 61-90 days due’ days, ‘above 90 days due’.
This data can also be compared with the company’s past performance or its competitors to notice the key trends. Generally, a huge percentage of accounts receivables in a higher bracket indicate poor management of receivables and a weak credit policy.