Many organizations evaluate the performance of credit department on the basis of DSO. We all know that Days Sales Outstanding (DSO) is a key performance indicator for the management of your accounts receivables. But is it the proper indicator to guage the performance of credit department? Credit period is could be a vital factor in DSO, and several times, credit period extended to customers is influenced by actions or decisions made outside of the credit department’s control. Seven reasons for extending credit to customers are given below:
1. Meet Competitors’ Terms:
Salespersons feel that we must always offer credit to our customers since our competitors are offering credit to our customers. They feel that if we don’t offer credit, our customers will start buying from our competitors and that we lose business.
2. Increase Sales:
If management feels that they will increase sales by extending credit to customers, they may extend credit to customers by availing credit facilities from bank.
3. Leverage During Negotiations:
Extending credit helps you win more business during purchase negotiations.
4. Higher Customer Loyalty:
Credit terms can result in higher customer loyalty. If customers feel that it’s easier to try and do business with you, and you are meeting all their needs, they are going to eventually stop searching for alternative suppliers.
5. Suppliers’ Terms:
If you’re getting credit from your suppliers, you’d wish to extend the identical credit terms to your customers.
6. Security Offered:
Sometimes management may extend credit to customers by taking some kind of security like bank guarantees, post-dated cheques, or LCs etc.
7. Liquidate Old Stock:
Management may offer extended credit period (or discount) to customers to liquidate non / slow moving stock.
You can see that in all the cases mentioned above, the choice to increase credit was made outside of credit department’s control. Hence, it’s not proper to measure the performance of credit department on the basis of DSO. Many organizations have started using Delinquent DSO also called as Average Days Delinquent (ADD) to measure the performance of credit department. Credit Controllers can request their management to evaluate their performance based on DDSO (ADD).
DSO = (Ending Total Receivables / Total Credit Sales) x No of Days in the Period.
The DDSO (or ADD) formula = DSO – Best Possible DSO.
Best Possible DSO = (Current (Not Due) Receivables / Total Credit Sales) x No of Days in the Period.