Too many advisors and small businesses still use aging reports to measure how well businesses are collecting payments. AR aging reports are simply a list of outstanding invoices grouped into buckets of 30 days, which might not even be appropriate for a particular business or industry. We can all do better.
We reviewed Days Sales Outstanding in a previous article as a metric frequently used to track how quickly payments are collected, and we introduced Tally DSO as an improvement on the older methods. But DSO doesn’t differentiate between payments that are on-time or late, which can obscure other problems. So let’s dig into two other key metrics: Average Days Delinquent and Days Beyond Terms.
Average Days Delinquent (ADD) is similar to DSO but only for late payments. ADD is so similar to DSO that some call it Delinquent DSO. In other words, ADD is the average number of days late payments were late.
The traditional way to calculate ADD is to first calculate the traditional DSO. Next, calculate the Best DSO, which is the ratio of current receivables to average sales per day. Then subtract the Best DSO from DSO to leave you with the Delinquent DSO (aka ADD). Got it!?
ADD = (Accounts receivable / Avg Sales per Day) - (Current Accounts Receivable / Avg Sales per Day)
This approach makes logical sense and might be good enough if you only have financial statements to use as a starting point. But it suffers from at least two shortcomings. First, it relies on “average sales per day,” which can change even if your collections period doesn’t change. Second, unpaid invoices get included and distort the results.
A better approach is to work from the bottom up and make the calculation using actual (and only) late payments. To do that we calculate the number of days between the late payment date and the invoice due date. Then we compute a weighted average number of days across all invoices with late payments during the period.
Real ADD = Sum(Late Payment x (Amt Payment Date - Invoice Due Date)) / Invoice Amts with Late Payments
The result is the actual, average number of days late that payments were received. Tracking this ADD along with DSO tells a more complete story, as we’ll see in the example below.
Getting paid late hurts cash flow, but not getting paid at all is really damaging! The key metric to understanding how late customers are at any given moment is Days Beyond Terms (DBT). Simply put, DBT is the dollar-weighted-average of the number of days that overdue invoices are past terms.
Tally Street calculates DBT by filtering on invoices that were overdue at the end of the reporting period, then summing the number of days between the reporting date and the due date, and then dividing by the total amount outstanding as of the same reporting date.
DBT = Sum for Invoices Overdue of ((Reporting Date - Due Date) x Balance) / Sum (Balances Outstanding)
Note that because DBT uses dollar-weighted-averaging, the ratio between the AR overdue and the total amount outstanding will skew the result. For example, if $100 is overdue by 10 days ($100 x 10 = $1000) and there is $200 outstanding, then the DBT is 5. But if there is $500 outstanding (still just the $100 overdue) then DBT is 2. So don’t think of DBT as the actual number of days money is overdue, but a measure of overdue pain!
DSO, ADD and DBT are valuable metrics, but no single one of them tells the full story. They must be evaluated together, along with knowledge of the underlying business, to discover opportunities for improving collections and boosting cash flow. This is when small businesses look to accounting, bookkeeping, and financial advisors for help!
For example, if DSO, ADD and DBT are all trending down then collection times are improving. But if DSO and ADD are trending down then late payments are probably increasing. If you see DSO and ADD moving in different directions then you probably need to dig into the details. For example, if DSO is rising while ADD is falling, the change in DSO might be the result of shorter credit terms and not an improvement in collections.
In the above example, DSO and ADD have been trending in the same direction and DBT remained fairly flat. The increase in DSO and ADD in March, while DBT slight decreased, suggests that some large overdue invoices were collected as overdue balances became late payments. Then after two months of improvements all three metrics start increasing, suggesting a notable degradation in performance, something your client needs to know!
Lastly, keep an eye out for the impact of disputed invoices. If customers delay payments while disputing invoices then DBT will increase as the overdue AR balance grows. If the dispute gets resolved and customers make payments, then there will be a bump in both DSO and ADD. If it’s more than a temporary problem and a growing number of invoices are being disputed, there could be serious problems with the sales process, the product or product delivery.