Construction companies need to evaluate their processes in order for them to understand what’s working and what isn’t. If, for instance, you are consistently struggling to maintain your cash flow due to frequent late payments, there may be something amiss in your collections processes or your credit policies.
Knowing which areas need improvement and which areas are effective is best done through the use of key performance indicators of KPIs. Applying KPIs will help you analyze and assess how well your accounts receivable department is doing.
What are collections department KPIs?
Key performance indicators or KPIs are quantitative metrics that allow you to track and monitor the performance of your credit collections department.
Different KPIs can track different aspects of your collections department team, from the amount of time it takes them to collect payment to the amount of profit that you generate per client. Some construction companies use one or two KPIs, while others apply a combination of multiple KPIs to have a more holistic appreciation for how well or how bad their collections department team is doing.
Note that using more KPIs does not necessarily mean that you are on the right track. It is imperative that you understand each and every KPI that you are using, how to measure them, and how to read the numbers that they tell you.
The importance of using collections metrics
You are strongly encouraged to incorporate the use of KPIs when assessing your work processes, particularly as they relate to payment collection. Late payments are common in the construction sector, and you want to minimize the risk of non-payment as much as possible.
One way of doing so is by applying KPIs to understand how well you are managing your accounts receivables. By using KPIs, you put yourself in better shape to make informed decisions and improve your payment collections practices.
Here are a few more reasons why you should consider using collections metrics:
- They help you quantify your collections department’s performanceUsing KPIs and other quantitative metrics allows you to limit the guesswork. Instead of relying on intuition or your gut, you can calculate the relevant KPIs, look at the numbers, and conduct an assessment or an investigation based on the calculated values. While numbers do not always tell the full story, they are arguably more reliable, more scientific, and more meaningful.
- They help you address the gaps in your current collection practices.Using KPIs will help you identify weaknesses in your existing processes. If, for example, your KPIs tell you that you are taking more than 90 days to collect payment from your clients, you may want to revisit your collection practices and investigate what is causing the delay. When you use KPIs, you are able to flag issues like this and prevent them from evolving into bigger issues.
- They help you identify areas or practices that are doing well.Using KPIs does not only help you identify your weaknesses, but they also help you identify your strengths. Knowing your strengths is just as important, as it allows you to keep on doing what works best for your business. Let’s say, for example, that 90% of your outbound collections calls end with your clients promising to pay. This means that you have a high Promise-to-Pay rate, which further implies that your staff is properly trained in doing collections calls.
Types of accounts receivable metrics
When determining what KPIs are best for your company, you should keep in mind two important areas: your collections processes and your collections staff. You want the ability to benchmark and evaluate your existing practices, and you also want to be able to assess the competence of your accounts receivable team.
The KPIs that you choose for your business must cover those two areas. Focusing on just one will not compensate for failing to address the other. Even if your credit policies and collections practices look good on paper, they will not be as effective if your staff is ill-trained in implementing them.
Similarly, you can hire the best staff and train them properly, but if your credit policies and collections processes are lacking, then your collections team will also not be as effective.
7 Accounts Receivable KPIs for Collection Departments
While there are certainly more than seven key performance indices that you can use, these are just some of the most important KPIs that you should consider:
Collection Effectiveness Index or CEI
The Collection Effectiveness Index or CEI is one of the most important KPIs in the construction industry. It is a metric that lets you know how much payment you were able to collect over a certain period of time. For example, if you are owed $100,000 in a month, and you were able to collect $90,000 in that same month, you have 90% CEI.
A CEI above 80% is considered a good CEI. If your CEI is consistently below 80%, it means that your collections department is not effective enough at turning invoices into cash.
Day Sales Outstanding or DSO
The DSO or Day Sales Outstanding is similar to the CEI and is also one of the most important KPIs in construction. When you measure the DSO, you calculate the number of days it takes you to collect payment from your clients. You want to make this number as low as possible.
A high DSO means that it takes you a long time to collect a payment, which suggests that something is amiss with your collections practices.
Profit per Accounts or PPA
Profit-per-account measures how much you were able to earn in profit compared to the number of delinquent accounts that you managed during the assessment period. Similar to CEI and DSO, this KPI measures the effectiveness of your collections department, specifically in terms of the profit earned.
A low PPA suggests lapses in your current collections practices. If you have a low PPA, you may be making ineffective collections calls, or you may be dealing with high volumes of payment disputes, among other possible reasons.
Average Days Delinquent or ADD
ADD or average days delinquent is a KPI that is best used with DSO. ADD measures how the average number of days that your invoices are past their due date. Comparing the DSO with your ADD allows you to gauge the overall performance of your collections department in a given period of time.
The DSO and the ADD typically go in the same direction. If, for example, your DSO is increasing over time, then your ADD is also likely to increase during the same period.
Accounts Receivable Turnover Ratio
The accounts receivable turnover ratio is a KPI that compares your net credit sales versus your accounts receivable over a specific time period. It is another KPI that helps you assess how well your collections department team is doing in terms of converting invoices into cash.
A high accounts receivable turnover ratio means that you are able to collect payment quickly, while a low accounts receivable turnover ratio implies that you may be lagging when it comes to collecting payment from your clients.
Promise to Pay Rate
The promise-to-pay rate, also called the PTP rate, is a KPI that determines the percentage of the outbound calls you made that resulted in a client’s promise to pay. If, for instance, you made 50 collection calls and 40 of those ended in a client promising to pay an invoice, then you have an 80% PTP rate.
Getting a client to promise payment is one way to determine if a collection call is successful or not, so ideally, you want to have a high PTP rate.
Cost of Collections
The cost of collections rate is a KPI that is particularly helpful for companies that utilize a third-party collections agency to pursue payment from delinquent clients. It compares the amount of money paid to the collections agency versus the amount of payment collected by the agency.
Ideally, you want the cost of collections to be low. If your cost of collections is high, you may want to assess if you are working with the right collections agency or if there are other possible solutions that you can look into.
Calculating your accounts receivable key performance indicators or KPIs
Collection Effectiveness Index
CEI = [(beginning receivables + credit sales – ending receivables) / (beginning receivables + credit sales – ending current receivables)]*100
You need the following to calculate CEI:
Beginning receivables – the amount available for collection at the beginning of the assessment period
Credit sales – the amount of sales made on credit
Ending receivables – the amount of open receivables at the end of the assessment period
Ending current receivables – the amount of open receivables minus overdue receivables
Day Sales Outstanding
DSO = (accounts receivables / net credit sales) * no. of days
You need the following to calculate DSO
Accounts receivables – the amount owed to you by your clients
Net credit sales – the net amount of sales made during the assessment period
No. of days – the number of days during the assessment period (e.g., month, quarter, year)
Profit per Accounts
PPA = gross profit/no. of delinquent accounts
You need the following to calculate PPA:
Gross profit – total revenue minus total operating expenses over a given period of time
No. of delinquent accounts – the number of delinquent clients managed during the given period of time
Average Days Delinquent
ADD = DSO – best possible DSO
You need the following to calculate ADD:
DSO – day sales outstanding (see above)
Best possible DSO – current accounts receivable divided by the billed revenue multiplied by the number of days
Accounts Receivable Turnover Rate
Accounts Receivable Turnover = net credit sales / average accounts receivable
You need the following to calculate the accounts receivable turnover ratio:
Net credit sales – the net amount of sales made during the assessment period
Average accounts receivable – the amount of accounts receivable at the beginning of the assessment period plus the value of accounts receivable at the end of the assessment period divided by two
Promise to Pay Rate
PTP = (the number of promises to pay / the number of calls made) * 100
You need the following to calculate the PTP:
Number of promises to pay – the number of calls that ended in a promise to pay
Number of calls made – the number of outbound collection calls made
Cost of Collections
Cost of Collections – (cost paid to the agency/total amount collected by the agency) * 100
You need the following to calculate the Cost of Collections
Cost paid to the agency – the amount you pay to the collections agency
Total amount collected by the agency – the total amount collected for you by the agency
Effective accounts receivable collections practices
- Standardize staff trainingYou need to ensure that your collections staff is properly trained, and you can do so by standardizing your company’s training process. Make sure that your collections team understands your trade credit policies and has all the basic competencies, such as making effective payment collection calls.
- Build a robust trade credit and collections policyYou must have a trade credit policy that aligns with your company’s goals, and that helps you assess the risks associated with every client. You must also have a standard set of procedures for addressing late payments and other collections concerns.
- Evaluate processes and staff regularlyTraining your staff properly and having a solid credit policy is not enough. You must regularly evaluate your staff and your current practices, so you are able to improve continuously. You are highly encouraged to apply the applicable KPIs when you conduct your regular evaluations.
3 credit metrics to determine your client’s debt capacity
One way to mitigate credit risks is to properly assess your client’s debt capacity. You may do so by applying credit metrics, such as the following:
Debt-to-equity ratio
The debt-to-equity ratio is the ratio between a company’s total liability and its total shareholder’s equity. It tells you how much a company owes versus how much they owe in net assets. A high debt-to-equity ratio is considered high risk, as it means that a company has more debt relative to the amount of assets that it can use as leverage.
Cash interest coverage ratio
The cash interest coverage ratio is a credit metric that measures a company’s ability to pay for interest. It compares the company’s net cash flow, including tax and interest payments, against the interest related to their current liabilities. The higher the cash interest coverage ratio, the better.
Debt-to-EBITDA ratio
The debt-to-EBITDA ratio is another credit metric that determines the ability of a company to decrease debt. It compares the total debt against the total earnings before interest, tax, depreciation, and amortization. A low debt-to-EBITDA ratio means that a company is in better shape to take on more debt, while a high debt-to-EBITDA ratio implies that a company may struggle to pay off additional liabilities.
Best practices in applying AR metrics
Be consistent in assessing your accounts receivable KPIs
You need to determine how frequently you are going to measure your KPIs. Some KPIs are typically measured annually, while others are more meaningful if done more frequently throughout the year. Being consistent in applying the KPIs is key. Otherwise, you will not be able to understand the trends and determine if your collections department is doing well or not.
Take advantage of available technologies
Instead of conducting your KPI calculations manually, it is best if you leverage technology and take advantage of available software that will make measuring your KPIs a lot easier. You can use Excel spreadsheets, or you can also use specialized software if you prefer. Making use of advanced technology will allow you to focus on understanding the numbers instead of calculating them.
Act on potential red flags right away
Using the right KPIs will help you identify potential risks, and it is best if you flag these risks right away. If, for example, your monthly DSO increased by a large number, you should go right ahead and investigate. It may be due to just one client, or it may be indicative of a bigger problem. Make sure to act on the red flags right away before they turn into major financial concerns.
Further reading