The efficient handling of accounts receivable stands as a crucial pillar for the success of any business. Among other crucial accounts receivable metrics, one key performance indicator takes center stage: Collection Effectiveness Index (CEI). This metric is a crucial indicator of how efficiently a company collects on outstanding receivables.
In this blog, we’ll break down CEI from its definition and calculation to understanding what the numbers mean and practical steps to enhance the collection process.
What is the Collection Effectiveness Index (CEI)?
The Collection Effectiveness Index (CEI) is a key performance indicator that provides insights into how effectively a company is managing and collecting payments on its accounts receivable. In simple terms, it measures the efficiency of converting outstanding receivables into actual cash over a specific period.
The CEI is calculated by comparing the amount of cash collected during a given period to the amount of cash that could have been collected, considering the starting and ending balances of accounts receivable. This index is expressed as a percentage and gives businesses a clear picture of their success in turning sales into cash.
A higher CEI indicates a more efficient and effective collection process, while a lower CEI may suggest challenges in collecting payments. Monitoring and analyzing the Collection Effectiveness Index can help businesses identify areas for improvement in their accounts receivable management, leading to better cash flow and financial health.
Why is the Collection Effectiveness Index Important?
Visibility over Collection Practices
The Collection Effectiveness Index is a vital performance metric that measures the effectiveness of your payment collection practices. A lower CEI signals that adjustments in the day-to-day operations of credit and collections teams may be necessary. It provides a clear insight into the efficiency of your collection processes.
Evaluation of Collection Policies
The Collection Effectiveness Index serves as a practical indicator to gauge how well your collection efforts are working. You can apply the CEI formula not just monthly but also over more extended periods to assess the overall quality of your collection practices. It’s a valuable tool for ongoing evaluation and improvement in your approach to managing receivables.
How to Calculate Collection Effectiveness Index?
Calculating the Collection Effectiveness Index involves a straightforward formula that takes into account the dynamics of receivables over a month. Let’s break it down step by step:
Beginning Receivables: This represents the total open receivables at the start of the month. Interestingly, it mirrors the ending total receivables from the preceding month.
Monthly Credit Sales: This encompasses the sales made by extending credit during the current month.
Ending Total Receivables: This accounts for all open receivables, including both current and overdue, at the close of the month.
Ending Current Receivables: This specifically refers to the open receivables that are not yet overdue.
Now, let’s put it all together in the Collection Effectiveness Index formula:
|CEI=[(Beginning Receivables+Monthly Credit Sales−Ending Total Receivables) / (Beginning Receivables+Monthly Credit Sales−Ending Current Receivables)] X100|
Let’s walk through an example to illustrate how to calculate the Collection Effectiveness Index using the provided formula.
Suppose XZY Inc. is analyzing its receivables for April:
- Beginning Receivables (April 1): $10 million (this is the same as the Ending Total Receivables from March 31)
- Monthly Credit Sales in April: $3 million
- Ending Total Receivables (April 30): $8 million
- Ending Current Receivables (April 30): $6 million
Now, plug these values into the CEI formula:
CEI=[($10 million+$3 million) − $8 million / ($10 million+$3 million) − $6 million] X 100
CEI=[($13 million−$8 million) / ($13 million − $6 million)] X 100
CEI=($5 million / $7 million) X 100
CEI ≈ 71.43%
The calculated CEI is approximately 71.43%. This means that XZY Inc. was able to collect about 71.43% of the cash that could have been collected during April, considering the dynamics of the receivables.
Interpretation of this percentage would involve assessing whether this level of collection effectiveness aligns with the business objectives and industry standards. A Collection Effectiveness Index of 100% is considered to be ideal, but it is an unrealistic number. In most scenarios, a Collection Effectiveness Index of 80% or above is considered to be a good percentage.
How to Interpret Collection Effectiveness Index?
Understanding and correctly interpreting the Collection Effectiveness Index is crucial for assessing receivable performance. Consider these factors for the interpretation of CEI:
Timely and Accurate Invoicing: Customers may not pay promptly if they don’t receive accurate and timely invoices.
Credit Policies and Payment Terms: Flexible credit practices and overly lenient payment terms can lead to a lower CEI.
Payment Flexibility: Customers have diverse payment preferences, and a lack of flexibility in payment options can affect cash collection.
Customer Prioritization: Efficient collection strategies involve prioritizing customers based on their payment behavior. If collectors spend too much time figuring out call priorities, it can lead to contacting the wrong customers and payment delays.
Proactive Collections Practices: Instead of waiting for invoices to become overdue, adopt a proactive approach to prevent payment delays.
How to Improve the Collection Effectiveness Index?
Improving the Collection Effectiveness Index involves regular monitoring and proactive measures. Here are some fundamental steps:
Offer Multiple Payment Options
Implement an accounts receivable solution that enables customers to make timely payments using their preferred payment method and currency.
Introduce automated workflows to the collections processes. This ensures timely delivery of invoices to the right contacts, with a focus on prioritizing high-risk accounts.
Streamline Invoice Management
Integrate accounts receivable solutions to ERP and accounting software to reduce manual data entry and invoice errors. Automate the invoice creation and delivery process for timely delivery.
Enhance Data Visibility
Provide AR teams with complete access to customer data, including payment history, communications, and contact details. This transparency aids in customer interactions, improves experiences, and reduces the chances of late payments.
Establish Robust Credit Policies
Develop and enforce strong credit policies based on factors like credit scores and payment history. Tailor terms to each customer appropriately to mitigate the risk of late payments.
Implement a Dunning Process
Despite proactive measures, late payments may occur. Have a well-defined dunning process in place to minimize the likelihood of invoices becoming severely delinquent.
To boost your Collection Effectiveness Index, it’s crucial to optimize your credit and collections process. An effective way to achieve this is by harnessing the power of accounts receivable automation solutions. This streamlined approach promotes efficiency and effectiveness in handling collections, ultimately contributing to a more robust financial management system.