Late payments cause financial stress for all companies. They reduce cash flow, leaving companies scrambling to find the money to pay their bills and their workers. Accounts receivable departments and credit managers are under tremendous pressure to collect payments within the credit terms the company sets. Measuring how late payments are received can help credit departments determine whether their collection efforts are successful or not. Metrics like average days delinquent, days sales outstanding, and other key performance indicators help these departments know where they stand so they can improve their efforts if they need to.
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What is average days delinquent?
Average days delinquent (ADD) is a metric that lets companies know the average number of days that late payments take to get collected. This isn’t a measure of how long it takes customers to pay their bills, just those that don’t pay within terms (usually 30 days). ADD is also called delinquent days sales outstanding (DSO). DSO is a measurement of how long it takes customers to pay invoices, whether it’s within terms or late, while the ADD focuses on just delinquent payments.
ADD indicates a company’s effectiveness in the collection process and their ability to convert their accounts receivable to cash. A higher ADD means that customers are taking longer to pay, while a lower ADD means they are paying close to on time. This index can be greatly affected by the collection processes that take place just before an invoice is due.
ADD versus DSO
Both ADD and DSO are measures of how long it takes customers to pay. However, they’re really measuring different things.
Days sales outstanding shows you how long it takes customers to pay your invoices over a period of time. It tells you how effective your collections process is, and how long it takes customers to pay on an overall basis, not just when they are delinquent.
Average days delinquent or delinquent DSO measures only late payments at a specific period of time, not over a period. It tells you, on average, how late payments are made right now.
Together these metrics can give you a good picture of how your collections are working. But you need to review them both, along with other indicators, before acting. This is because changes to your AR balance can affect your DSO without affecting the ADD. This may make you think you’re doing better with collections when delinquent payments are still outstanding.
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How to calculate your average days delinquent
In order to calculate average days delinquent, we must first find both the average DSO and the best DSO. Here’s how:
DSO = (Accounts Receivable Balance / Billed Revenue) x days in period
Best DSO = (Current Accounts Receivable Balance / Billed Revenue) x days in period
The Current Accounts Receivable Balance is the amount that is within your company’s payment terms. If your terms are net 30, it would be the AR balance within 30 days. If your terms are net 45, then it would be the AR balance within 45 days.
Once you have calculated the average and best DSOs, you are ready to calculate ADD.
ADD = Average DSO – Best DSO
Example of ADD calculation
Let’s look at an example:
Say your average AR balance is $300,000 and you’ve billed $1,500,000 over the past year. Your average DSO for the year would be 73 days.
($300,000 / $1,500,000) x 365 = 73 days
Next, you need to figure out your best possible DSO. If your current AR balance is $120,000 out of the $1,500,000 you’ve billed over the past year, your best possible DSO would be 29 days.
($120,000 / $1,500,000) x 365 = 29 days
Subtract the best possible DSO from your average DSO to find your ADD. In this case, your ADD would be 44 days—which means that, on average, your company is collecting payments roughly 44 days after they are due. If your terms are net 30, it’s taking an average of 74 days to collect late payments.
How to reduce ADD and speed up collections
Improving communication and visibility both with your customers and your business can help reduce your overall average days delinquent.
Learn more about buffing up your credit and collections policy.
Follow up with customers consistently
If your customers are taking a long time to pay invoices, in other words, if your ADD is high, you may want to improve the consistency of your follow-up with customers. Contacting customers on a regular basis to remind them of their payment status can help improve collection times.
Follow-up should be both written and by phone call, if necessary. Your credit policy should list all the steps you take when an invoice becomes past due.
Set clear expectations for payment from the beginning
Another way to speed up payments is to ensure that your customers know what to expect as far as collection processes when they begin their relationship with you. Make sure your credit documents set the expectation of prompt payment up front. Let your customers know of any penalties or fees that will be assessed when payments are late, as they often act as a deterrent and will encourage paying on time.
Maintain your payment rights
Construction contractors and suppliers should follow mechanics lien laws to protect their payment rights. In some states, preliminary notices are required when an order is placed, or a contract is signed. By submitting the necessary paperwork, you ensure that you can use the lien process to collect outstanding invoices without having to go to collections or file a lawsuit.
The best ways to improve your accounts receivable collections are to have a clear credit policy, follow-up with customers on late payments, and protect your payment rights. Doing these things will improve your cash flow, helping your business stay financially healthy and continue to expand and grow.