How to Measure Credit Performance

This article is a reprint of Wise Bread's contribution to OPEN Forum from American Express -- where small business owners can get advice from experts and share tips with each other.

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Measuring credit performance is useful in judging the effectiveness of the credit function, monitoring the impact of credit policies (including new ones designed to fuel sales or those implemented to speed up cash flow), uncovering problems, and recognizing successes.

There are many ways to evaluate credit performance: traditional methods commonly employed by large corporations and accepted as standard measurements, company-specific measurements aligned precisely with current business goals, and more.

Traditional Measurements

Accounts Receivable Aging represents the status of credit accounts. A/R aging reports categorize current and past due balances (generally 30, 60, 90, and 120+ days past due), displaying absolute dollar amounts as well as percentages of total receivables. This information may be segmented by individual customer, distribution channel, or other category to more easily detect problem areas and measure progress in addressing credit concerns.

DSO (days' sales outstanding) = (Total Account Receivables ÷ Total Credit Sales in Period) x Number of Days in Period gives a credit performance indicator, well recognized as a key measure among credit professionals. This number measures how long your company waits for payment after sending an invoice. (Credit sales are sales for which payment is not received immediately.)

Both A/R Aging and DSO can require staff and system resources dedicated to opening credit accounts, establishing and monitoring credit lines, managing accounts receivables, and producing monthly (or more frequent) A/R reports and calculations.

DSO as a performance measurement may be more useful for relatively large companies in mature industries for several reasons. They tend to have:

• historical comparisons that are relevant to evaluating DSO, which is most meaningful when placed in context of past results; trends in DSO may signify improving or deteriorating performance as well as seasonality using month-to-month or quarter-to-quarter comparisons;
   
• industry benchmarks that also provide context for comparisons to competitors servicing the same customers and offering similar credit terms;
   
• steadily growing or relatively stable sales booked throughout each month, rather than fast growing or fluctuating sales that may skew DSO results.

In addition to standard DSO, there are variations of DSO that give additional perspective on credit performance; these include:

• BPDSO (Best Possible DSO) = (Current Receivables ÷ Total Credit Sales in Period) x Number of Days in Period

• DDSO (Delinquent DSO a/k/a Average Days Delinquent or ADD) = DSO - BPDSO

If DSO and DDSO are lower than industry benchmarks or trending lower historically, then credit performance is positive. If the difference between DSO and BPDSO is shrinking, then performance is improving.

Measurements Aligned with Business Goals

Measurements can quantify attainment of specific goals as mentioned in my articles on the Components of a Sales-Driven Credit Function and How to Design Credit Policies.

For example, if your goal is to increase sales with customers in an emerging sector by extending credit, track credit performance (actual vs. projected) by measuring:

• number of new credit accounts;
• value of credit lines extended;
• growth in credit sales;
• growth in A/R balances, all specific to this sector.

If your goal is to speed up the credit application process, then measure how quickly customers are granted credit lines or denied credit. If your company needs a certain amount of cash to operate, then focus on measuring and monitoring daily cash receipts.

Applying these measures can determine the impact of policies on business indicators such as sales growth, and help predict how new policies may influence future results.

Collections-oriented Measurements

A quick-and-dirty calculation of credit and collections performance is Sales Collected ÷ Amount of Credit Sales = % Received.

For a more sophisticated calculation, use the Collection Effectiveness Index (CEI):

(Beginning Receivables + Credit Sales for Period - Ending Total Receivables) ÷
(Beginning Receivables + Credit Sales for Period - Ending Current Receivables)
x 100 = CEI

CEI was developed by the Credit Research Foundation to give a more precise reflection of credit and collections performance for companies with fluctuating sales.

For these measurements, optimal results are 100% or 100 indicating prompt collections of all receivables within the time period being evaluated.

Established businesses in mature industries may be more focused on traditional indicators such as A/R Aging and DSO; rapidly growing companies and those experiencing changing economic conditions might use both traditional and goal-specific measurements.

No matter what measurements are selected, evaluations of credit performance should spur actions that improve profitability and speed up cash flow. These actions might include:

• reducing credit limits to a handful of troublesome accounts while increasing credit lines to financially strong, consistently current accounts;
• reducing standard credit terms from 60 to 45 days;
• introducing new payment options;
• contacting slow-pay accounts before they have past due balances;
• defining priorities of collection calls;
• automating invoice preparation functions.

You might uncover problems, such as billing discrepancies, which affect timeliness of customer payments and ultimately credit performance.