You probably don’t have to be told that payments are slow in the construction industry. Contractors and suppliers often wait close to 90 days to get paid. Do you know how long it takes your company to get paid?
There are several ways to measure how long payments take. We’re going to look at four of them in this article. Using these key performance indicators, you can adjust your collections procedures and set new goals to help speed up payments.
Accounts receivable current percentage
Accounts receivable current percentage measures the percentage of receivables that are current. Depending on your credit terms,current invoices may be those billed within the last 30 to 45 days. This percentage tells you how much of your receivables aren’t beyond your payment terms.
To calculate the current percentage:
AR Current percentage = Current amount of open receivables / Total receivable balance
For example, if $50,000 of $100,000 in receivables is current, the current percentage would be 50%.
If only $25,000 of the $100,000 is current, the current percentage would be 25%.
Accounts receivable turnover (ART)
Accounts receivable turnover measures how efficiently a company collects payment from its customers, and how quickly it converts its accounts receivable (short-term debt) into cash. The accounts receivable turnover ratio shows how many times the company has converted its accounts receivable into cash over a certain time frame. In other words, the more frequently your receivables are turned over, the more effective your collection efforts will prove. You can calculate the ART on a monthly, quarterly, or yearly basis.
The accounts receivable turnover rate is calculated by:
ART = Net credit sales / Average accounts receivable balance for the time period
Net credit sales are calculated by subtracting any returns from the revenue from credit sales for the period.
To calculate the average accounts receivable balance, add the beginning AR balance to the ending AR balance, and then divide the sum by two.
For example, we’ll measure the ART for a month that has 31 days. The net credit sales for the month were $200,000. The beginning AR balance was $60,000, and the ending balance was $150,000.
To calculate the average AR balance, add $60,000 plus$150,000 and divide by two, which gives us $105,000.
The accounts receivable turnover rate for the month is calculated by dividing $200,000 (net credit sales) by $105,000. We get an answer of 1.9. This means the company has collected 1.9 times the average receivables in the month.
To get the average time it takes our customers to pay their balances, we take 31 (the number of days in the month) and divide by 1.9, for a result of 19 days.
Collection effectiveness index (CEI)
The collection effectiveness index is a measure of your ability to collect funds from your customers. It compares the amount collected in a time period to the receivables available for collection during that period. CEI is expressed as a percentage – the higher the percentage the better your collections are.
Looking at a specific period of time, you need to know four numbers to calculate CEI:
1. Beginning balance in Accounts Receivable (AR)
This is the amount in AR at the beginning of the period.
2. Credit sales during the current period
The amount of sales you made on credit during the period — the amount of new AR you added.
3. Balance of current receivables
The total of payments you received for credit sales made during the period.
4. Ending Total AR Balance
The amount in AR at the end of the period.
Here’s the formula to calculate your Collection Effectiveness Index for a specific period:
CEI = (Beginning AR Balance + Credit Sales during Period– Ending Total AR Balance) divided by (Beginning AR Balance + Credit Sales during Period – Ending Current AR Balance) multiplied by 100
To illustrate how the CEI is both calculated and impacted by payment collection, let’s examine this example.
Here are the balances and activities for August:
- Accounts Receivable Balance on July 31 = $100,000
- August Credit Sales =$25,000
- Payments Received on August Receivables = $20,000
- Payments Received for Outstanding Receivables = $50,000
Using this information, we’ll now calculate the variables we need to complete the CEI calculation:
- Beginning Receivable Balance = $100,000
- Credit Sales during August= $25,000
- Current Receivables Balance on August 31 = $5,000 ($25,000 in current credit sales minus $20,000 inpayments)
- Total Receivables Balance on August 31 = $55,000 ($100,000 beginning balance plus $25,000 in sales minus$70,000 in total payments)
Here’s the first part of the CEI calculation: (Beginning Receivable Balance + Credit Sales during Period – Ending Total Receivables Balance): $100,000 + $25,000 – $55,000 = $70,000
Now for the second part: (Beginning Receivables Balance +Credit Sales during Period – Ending Current Receivables Balance): $100,000 + $25,000 – $5000 = $120,000
To finish the CEI calculation for the month, we divide$70,000 into $120,000 to get 0.58. Multiply that by 100 to get 58%.
To show how additional collections affect your collection effectiveness index, let’s say that we were able to collect $75,000 of past due invoices, instead of $50,000. This would change our Payments Received for Past Due Invoices to $75,000 and change the Ending Total Receivables Balance to $30,000 ($100,000 + $25,000 – $20,000 – $75,000).
Now when we perform the calculation for the first part of the CEI formula, we get: $100,000 plus $25,000 minus $30,000 = $95,000. Divide $95,000by $120,000 and multiply it by 100 to get a CEI of 79%.
Since we were able to collect more past due receivables, the collection percentage went up.
Days sales outstanding (DSO)
Days sales outstanding tells you how long customers take to pay their invoices over a period of time. For example, you can analyze the days sales outstanding for a month, quarter, or a year. The higher the number, the more days you wait for payment.
To calculate DSO we can use the following equation:
DSO = (Accounts receivable balance / net credit sales) x days in period
For example, let’s say we have an accounts receivable balance of $1.2 million at the end of August. We made $1.5 million in credit sales during the month.
To calculate the DSO, divide the AR balance ($1.2 million)by total credit sales ($1.5 million) and multiply that answer by the number of days in the month (31).
$1.2 million / $1.5 million x 31 = 24.8
This means we collected payments an average of 25 days after invoicing during the month of August.
Now if we change the ending accounts receivable balance to$1.4 million, let’s see how the DSO changes.
$1.4 million ÷ $1.5 million x 31 = 28.9
By changing the AR balance, the DSO was increased by four days.
Get the knowledge you need
By referring to the key performance indicators (KPIs) presented in this article, you can gauge the payment processing duration and establish objectives to reduce that timeframe. Waiting for payments can cause cash flow problems for contractors and suppliers. Speeding up collections is one way to improve your cash position so you can afford to expand your business.
MX Build wants to help streamline the payment application and payment process with electronic transactions. Contact us today for a demo.