Important metrics in Credit Departments

In today’s uneasy economy with conflicting economic messages, nearly every trade creditor should be maintaining low bad debt and a strong cash flow position.  We all know this is not the case with many companies, therefore we will dive deeper into the metrics of the receivables management processes and determine how a more accurate representation of a company’s true cash flow efficiency and position can be achieved.

Critical cash flow forecasting is what CFOs need but don’t receive from their credit managers. This component is important because it measures customer payment performance and the impact of it on cash flow forecasts. Rather than simply measuring bad debt as a percentage of sales, it is important to assess the effectiveness of a credit risk process by examining the performance of the customer payments. Is our conclusion that the customer paid when we predicted they would?

“Basically, we’re looking to answer two questions: Is my Credit Department effectively managing the trade receivables asset, and are we spending the right amount of resources to manage it?” 

– Pam Krank, President, TCD

Important Metrics in Credit Departments 

When companies are struggling to quickly turn their trade receivables to cash, it is critical to determine why the performance gaps exist. Through a series of interviews, process mapping, and a resource analysis, we can better understand the issues causing the problems. 

It is comprehensive data analytics and the comparing of useful metrics that provides solid evidence of the performance issues in a Credit Department, by assessing both the effectiveness and the efficiency of the receivables management process.  In this discovery process we are seeking answers to two questions: Is my Credit Department effectively managing the trade receivables asset?  Are we spending the right amount of resources to manage it? 

As trade receivables process consultants, we are usually called on by CFO’s and Private Equity Firms to assess Credit Departments that are ineffective or inefficient. Often times, financial leaders have witnessed chaos in the process.  They lack confidence in the credit team’s responses to information needs and are usually not happy with the overall performance of the department. 

Surprisingly, standard metrics like DSO, Best Possible DSO, Average days delinquent, and Collection Effectiveness Indexes don’t always give us a clear picture of performance. Sometimes these metrics provide “false positives”, which lull companies into believing their Credit Department performance is well-managed and high performing. It isn’t until challenges like a recession, large credit loss or acquisition of a more difficult portfolio reveals that the department needed changes. 

So how do we evaluate performance if traditional metrics don’t always tell the full story? The answers often reside in the alternative measurements that meet more of the CFO’s need for information. 

Alternative effectiveness metric: bad debt versus slow pay predictives

We regularly see companies touting their low bad debt results as an example of their  excellent credit risk processes. Generally, that is not the true scenario experienced. Unless you’re selling into an extremely high risk customer base, nearly every trade creditor today should have low bad debt write-offs.  A strong economy and cheap, easy money for companies to borrow keeps all but the worst performing customers from defaulting on their unsecured debt. 

If most Credit Departments already have low bad debt write-offs, how do we then measure effectiveness of credit risk processes? Rather than simply measuring bad debt as a percentage of sales as is most common, we assess the effectiveness of a credit risk process by examining the performance of the customer payments. Did the customers pay the way we predicted they would? 

Today we can readily measure the accuracy of the financial risk models and credit scorecards. However, it is much more helpful to the business when we can measure the predicted risk of slow pay versus actual performance of the customer payments. 

Critical cash flow forecasting is one of the top skills CFOs need but don’t receive from their Credit Managers.  The larger impact of customer slow payments versus defaults in the portfolio is the primary reason we study slow pay performance over customer default. Credit Departments need to spend much more time on measuring customer payment performance to feed into the cash flow forecasts. This means tracking average days to pay by customer by month as well as predicted days to pay of customers before they start purchasing. 

How payment performance is measured 

Credit Departments should be able to predict actual customer payment performance during the risk assessment by answering the question “What can the customer afford to pay within stated terms?” 

The more accurate the credit lines are, the higher the probability payments will occur on time.  If the Credit Department recommends a $10,000 line, and the customer is kept to this line, then we can usually predict prompt payment performance of that customer as long as their exposure remains under $10,000. When we measure the actual payment performance against the predicted payment performance set during the credit analysis, we have our metric. This metric produces the “predicted days to pay”, creating a more accurate forecast which is critical to the needs of the CFO.  Additionally, it shows that the past due was not a failure of the Credit Department to not collect. Rather, it was a strategic business decision to extend beyond the $10,000 approved line. 

Alternative efficiency metric: department productivity 

Companies are not only interested in the effectiveness of their Credit Department, but also care deeply about the efficiency of the department. Certainly, we can compare department spend and staffing to competitors’ Credit Departments. This metric is simple to measure, but it does not answer the question of efficiency in a particular department due to large variances between companies and their receivable assets. Rather, more weight needs to be given to metrics that compare productivity within the department.  Can this metric answer the question “Are we the most efficient we can be?” 

Efficiency metrics are the easiest way to identify opportunities in the receivables management process. We have discovered, from extensive studies conducted on TCD clients, that Credit Departments with specialists are more efficient and effective than Credit Departments where generalists do bit of everything in the department.  It is also easier to measure productivity of specialists than with generalists. There seems to always be an opportunity for efficiency improvements in a department of generalists. 

The top metrics for credit department members include:

• Collectors: calls per hour* (small business customers)
• Credit Analysts: Credit parent files analyzed per hour
• Portal analysts: items worked/reconciled on the customer portals
• Deduction analysts: deduction files worked per hour 

It is best to study these metrics over a time period in order to measure changes within the department.  We may see wide ranges of metrics for collection calls as an example, from five accounts to 30 per hour depending on complexity of the collections and type of customer base.  As Peter Drucker noted 40 years ago, “What gets measured gets improved”.  Performance always seems to improve dramatically when CFOs receive regular performance metrics of their credit departments.

Ongoing Critical Metrics Monitoring

Credit Department metrics should be updated frequently.  For example, on a weekly basis we provide  metrics to our CFOs that outsource their receivables management to TCD.  

The most popular metrics requested by CFOs (in order of importance): 

• Variance in Cash flow projected versus Actual cash received 
• Historical tracking of weekly agings, numbers of past due items and DSO calculation 
• Variance in Major Accounts, Disputes and Process Challenges vs prior periods 
• Variance in credit exposures/average days to pay by customer versus approved credit lines and predicted average days to pay 
• Average dispute/deduction routing time by department 

Many of these metrics that top finance leaders are seeking include high level analytics that tell them something about the asset that they can’t readily see themselves. You must be prepared to answer the “why” questions on performance. Credit Departments should consider what’s important to their Finance Leaders when creating and distributing metrics. We’re responsible for ensuring all important metrics are continually measured and disseminated to those in need of the data. Credit Managers should seek out additional metrics when traditional measurements no longer suffice in providing sufficient warning to management of risks to the portfolio and expected cash flow of the receivables asset. 

Effectiveness and efficiency are key to your receivables management process. If you aren’t measuring both areas, you may not be getting an accurate picture of your trade receivables management.

Since 1993, The Credit Department has provided sophisticated portfolio risk analysis with a level of expertise and technology that originated in F-100 credit departments. We have taken that knowledge and elevated it to real-time credit monitoring and risk analysis that equals real dollars saved and legal proceedings avoided.

Contact us for a free consultation to review how TCD can help your company reduce risk, manage debt, and improve metrics.