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6 accounts receivable metrics small businesses should track

A small business owner working from home uses a laptop to manage accounts receivable online.

Getting paid on time and in full shouldn’t feel like a magic trick. Still, according to a survey we conducted in 2021, as many as 59% of small and medium-sized businesses (SMBs) experience late payments. These practices hurt cash flow, which results in significant damage to SMBs and is often cited as the number one reason why they fail. And we haven’t even started talking about possibly lost funds and bad debt. 

Luckily, there are proactive measures businesses can take to improve their accounts receivable (AR) process and ensure smooth payments. The first step is to identify and start tracking the most crucial AR metrics so you’ll know what areas in the process are going well and what needs more work. 

Before we cover the key accounts receivable metrics you should track, let’s quickly cover some basic terms to make sure we’re all on the same page.

What’s accounts receivable?

AR refers to all open invoices issued by a business for goods or services already rendered. Open or unpaid invoices are common in business-to-business (B2B)Business-to-business (B2B)Business-to-business refers to operations done between businesses. B2B payments are transactions made between two businesses or companies. deals that are typically paid with net terms. 

Consumers pay on the spot, often even before they receive the goods, so these transactions go straight into the business’s register. But when it comes to B2B transactions, things get a little more complicated. Businesses usually receive an invoice with a future due date, usually after they already got what they’re paying for. They then have 30, 60, or even 90 days to pay, depending on the net terms they agreed upon with their vendors. 

Until the invoice is paid in full, it’s considered accounts receivable. Since it’s money that’s expected to arrive in the near future, AR is listed as an asset on the balance sheet.

Why is AR so important to small businesses?

Simply put: no business can survive, let alone thrive, if it doesn’t get paid. Small businesses are especially vulnerable to cash flow issues as their pockets are never as deep as those of bigger competitors. So, any accounts receivable entry that isn’t collected on time (or at all) represents a potential risk to the business’s financial health and longevity.

A good accounts receivable management process means payments are coming in faster, cash flow is healthier and more predictable, profitability is higher, and fewer funds are lost.

How tracking key metrics helps improve the AR process

We’ve already established that a good and efficient accounts receivable process is crucial but how can you tell if you have one? That’s where key metrics, also known as key performance indicators or KPIs, fit in. 

By tracking selected metrics you can evaluate your current situation, compare it to other businesses, identify areas where you can improve, and monitor your progress over time. That’s true for AR as well as any other process you’re looking to examine in your business.

The top 6 AR metrics to track

Monitoring these KPIs will give you a good idea of how efficient your small business’s accounts receivable process is, and what you can do to improve it.

1. Days sales outstanding (DSO)

DSO refers to the average collection time per invoice issued. In other words, the number of days it takes your customers to pay an invoice, on average. Turning AR into cash more quickly means fewer cash flow issues and less time wasted on chasing payments. A DSO of under 45 days is generally considered good, but the lower your DSO the better.

It’s important to note that cash sales are never factored into DSO calculations as this metric only applies to credit sales and measures the efficiency of the receivable process.

DSO is sometimes also referred to as days receivables or average collection period.

DSO is calculated over a period of time, typically quarterly, according to the following formula:

Total accounts receivable ÷ total credits sales × number of days = DSO

So, let’s say that during the last quarter of the year, your business had $60,000 in total accounts receivable and $150,000 in total credit sales, which includes deals that have already been paid for. 

To calculate the DSO, we’ll first divide 60,000 by 150,000, so we’re left with 0.4. We’ll then multiply that by the number of days in the examined period, which is 92. So the DSO for this quarter is 36.8. 

This is what it looks like:

60,000 total AR ÷ 150,000 total credit sales × 92 number of days = 36.8 DSO

2. Best possible days outstanding

Like DSO, this metric refers to the number of days it takes the average invoice to be paid. The difference is that past-due invoices are not factored into the best possible DSO, which only refers to current receivables. In other words, it only measures the time it takes customers who comply with your terms to complete the payment.

It also uses net credit sales, which is the sum of your total credit sales after deducting any discounts, returns, or other allowances made to customers. 

While it’s not likely that your DSO and best possible DSO will be the same, you should strive for the numbers to be as close as possible and for your standard DSO to be no more than 20% higher. 

Best possible DSO is calculated using the following formula:

Current accounts receivable ÷ net credit sales x number of days = Best possible DSO

Say your business had $30,000 in current accounts receivable and $80,000 in net credit sales in the last quarter of the year.

To calculate the best possible DSO, we’ll first divide 30,000 by 80,000, so we’re left with 0.375. We’ll then multiply that by the 92 days in the examined period. So the best possible DSO for this quarter is 34.5. 

Here’s what it looks like:

30,000 current AR ÷ 80,000 net credit sales × 92 number of days = 34.5 best possible DSO

3. Average days delinquent (ADD)

Also referred to as delinquent days sales outstanding, ADD represents the average number of days your invoices are past due. 

Tracking this metric helps detect trends such as when a customer repeatedly jeopardizes your cash flow or even becomes a bad debt risk. If, for example, your average past-due invoice is paid within a week but you have one customer who consistently pays two or more weeks after the due date, it may be time to reconsider doing business with them. 

Here’s how to calculate average days delinquent:

DSO – best possible DSO = ADD

So, drawing from the examples above, let’s assume your DSO is 36.8 and your best possible DSO is 34.5. All you need to do to calculate your ADD is to subtract 34.5 from 36.8 leaving you with a 2.3 ADD. 

In formula form, it looks like this:

36.8 DSO – 34.5 best possible DSO = 2.3 ADD

4. Receivables turnover ratio

The turnover ratio measures how efficiently AR is converted into cash. The turnover ratio reflects how many times a business collects its average accounts receivable during a given period. 

Generally speaking, a higher turnover ratio means your accounts receivable process is efficient and you are consistently collecting what you are owed. 

However, if it’s too high, it can also indicate you have conservative and restrictive payment terms in place and don’t extend enough credit to customers. This can become a problem as good payment terms often give businesses, especially those in the B2B realm, a competitive edge. 

The exact ratio to strive for varies greatly depending on your industry and what payment terms are considered acceptable. For example, the average ratio for the transportation industry is 9.38 and 4.32 for professional service providers, according to an analysis by research firm CSIMarket.

The turnover ratio is calculated for a specific period according to this formula:

Net credit sales ÷ average accounts receivable = turnover ratio

To figure out your average accounts receivable, add up the period’s starting and ending AR balance and divide it by two. 

Let’s say your net credit sales over the last quarter amounted to $120,000 and your accounts receivable balance was $20,000 in the first month of the quarter and $25,000 in the last month. 

First, let’s calculate your average accounts receivable by adding up 20,000 and 25,000. This brings us to 45,000. We’ll divide that by two to reach the average AR of 22,500. 

Now, we’ll divide 120,000 (your net credit sales) by 22,500 (average AR). We’ll end up with a turnover ratio of 5.33. 

This is what it looks like:

120,000 net credit sales ÷ 22,500 average AR = 5.33 turnover ratio

5. Collection effectiveness index (CEI)

This metric reflects the percentage of receivables a business was able to collect over a specific period, typically quarterly. Anything above 80% is considered a good CEI score.

To calculate your collection effectiveness index score, use the following formula:

(Beginning AR + average monthly credit sales – ending total AR) ÷ (beginning AR + average monthly credit sales – ending current AR) × 100 = CEI

As an example, let’s look at a quarter with the following numbers: 

Beginning total receivables: $32,000

Ending total receivables: $28,000

Ending current receivables: $21,000

Monthly credit sales: $18,000 for the first month, $15,000 for the second, and $13,000 for the third. 

Average monthly credit sales: ($218,000+$15,000+$13,000) ÷ 3 = $15,333

To calculate the CEI we’ll:

  1. Add up 32,000 (beginning total AR) and 28,000 (average monthly credit sales). We’ll get 60,000.
  2. Subtract 28,000 (ending total receivables) and get 32,000.
  3. Repeat step one and subtract 21,000 (ending current receivables) from 60,000 to receive 39,000. 
  4. Divide 32,000 by 39,000 to get 0.82.
  5. Multiply by 100 to reach the CEI: 82%.

Here’s how it looks with the numbers put in:

(32,000 beginning AR + 15,333 average monthly credit sales – 28,000 ending total AR) ÷ (32,000 beginning AR + 15,333 average monthly credit sales – 21,000 ending current AR) × 100 = 82% CEI

6. Bad debt to sales ratio

This metric measures the ratio between a company’s sales and its bad debt. 

Bad debt is any money a company is owed and cannot collect for whatever reason. This could happen when a customer goes bankrupt or when a disagreement can’t be settled among other scenarios. Bad debt is written off as a loss or an expense in your company’s records. 

When a debt is considered bad varies between businesses and industries. For example, some define invoices as bad debt once they’re 90 days past due while others use six months as a benchmark. 

Here’s the simple formula for calculating bad debt to sales ratio:

Bad debt ÷ total sales × 100 = bad debt to sales ratio

So, if you have an annual bad debt of $12,000 and $200,000 in sales, you’ll need to first divide 12,000 by 200,000, arriving at  0.06. Then, multiply by 100 to reach your ratio of 6%.  

Here’s what it looks like:

12,000 bad debt ÷ 200,000 total sales × 100 = 6% bad debt to sales ratio

A bad debt to sales ratio of under 15% is generally considered okay. If your ratio is higher, you should get proactive to reduce it before it becomes a serious issue. Here’s what you can do:

  • Change your credit and net-terms policies. If your ratio is high, it’s possible you’re being too generous with your payment terms. Perhaps you don’t charge any late fees or you’re extending too much credit. Unfortunately, being too flexible can encourage some customers to take advantage.
  • Fire customers who produce bad debt. Doing business together is about trust. If a business customer isn’t paying, they’re breaching your trust and basically stealing from you. Immediately terminate all ties and projects with customers who fail to pay. Also evaluate whether you should keep customers who are consistently late with their payments as this tardiness (harmful enough in itself) can, at some point, turn into bad debt too.
  • Improve your collection process. Send timely reminders, make it easier to pay by accepting a variety of payment methods, and give customers the option to pay online. All of these actions will make it less likely for customers to default on your invoices.

Hit every mark by digitizing AR

Tracking these six AR metrics will give you a much better idea of how your collection process is going and where you can improve. It will also let you see your progress over time and reassess. 

Using a digital payment platform like Melio to manage your accounts receivable will help you fix some of the glitches you may find, improve your accounts receivable KPIs, and ensure faster and smoother payments. 

Here’s how: 

  • Flexibility and choice. Both you and your customers get to choose the payment methods that work best for you. Want to receive a bank transfer but your customer only wants to pay by credit card? Not a problem! 
  • Trackability. A digital AR tool lets you easily track unpaid invoices from anywhere and send payment requests and reminders to your customers as needed. 
  • Less clutter. Paper invoices, checks, and envelopes have the annoying habit of getting lost, stolen, or stained. Going digital means you’ll never have to search for another piece of paper again. Instead, you’ll just get paid. 
  • Access from anywhere. Your customers don’t need to be at their desks in order to pay. They can use any device with an internet connection to settle the bill in minutes. 

Sign for Melio today to get started. 

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*This blog post is intended for informational purposes only and is not intended as financial advice.
**Melio does not provide legal, tax or accounting advice, and you should consult with a professional advisor before making any financial decisions.