While metrics such as EDSO, or even DSO, are useful gauges of receivables performance trends, they only present one aspect of a complex environment. Knowing how long, on average, customers are taking to settle their invoices is quite useful. However, this statistic is most relevant when it is compared with the average amount of time that they have been granted to pay. Clearly, for a comparison of credit period taken to credit period granted to be relevant identical data sources or samples must be compared.
The article entitled "EDSO (Enhanced Days Sales Outstanding) – finally, a receivables metric that cannot be distorted!" from Quarterly Review – Volume 1, Issue 1 detailed the process and logic behind Moneypower International’s EDSO metric. EDSO provides an accurate and scaleable method of measuring customer payment times. The Average Terms concept works very similarly. In fact, the same equation is used to calculate Average Terms – with the days of credit granted substituted for the elapsed days.
Average Terms Formula
The formula used to calculate Average Terms is as follows:
X = invoice values (or parts)
Y = elapsed days
To highlight the ease with which Average Terms can be calculated, the following example is offered:
Average Terms – a two invoice example
- The first invoice has a value of $10000; was issued on October 2 2004; has a due date of November 2 2004
- The second invoice has a value of $15000; was issued on October 9 2004; has a due date of November 20 2004
The first invoice’s value of $10000 is multiplied by the credit days granted (32) to provide a result of 320000. The second invoice similarly yields a result of $15000 times 43 or 645000. The two results are summed to provide a figure of 965000, which is divided by the total of the two invoice values ($10000 + $15000), to give Average Terms of 38.60 days.
Scalability
As with EDSO, Average Terms can be scaled from various A/R portfolio segments, all the way up to the entire portfolio population. Among the most useful levels at which Average Terms can be calculated are:
- Customer
- Customer Group (i.e. public or private sector)
- Product Lines
- Business Unit
- Salesperson
Of course, combinations of segments are also particularly useful. For example, a combination of salesperson and customer group provides insight into the behavior and effectiveness of the salesperson in negotiating with particular customer types.
How to use Average Terms as a basis of diagnosis
The Average Terms metric can be used in a number of ways to diagnose particular performance or customer relationship issues. Among the potential areas of concern that can be identified through analyses of Average Terms, or from a comparison of Average Terms to EDSO include:
- Input errors during the order processing procedures
- Software coding issues preventing the input of the terms actually granted
- Organizational policy issue contravention
- Terms that are either too restrictive or too lenient compared to what the market or environment dictate
- Customer segments that could be controlled more effectively through updated collection and management techniques
Once the organization is able to identify areas of potential concern, it can address appropriate remedial action.
Neil G Van Luven - Founder