Poor cash management is one of the leading causes of revenue leakages. In fact, if this issue is not addressed, the losses could accrue to a point where it leads to bankruptcy! However, as an artist or a creative professional, monitoring or improving cash flow might seem like a challenging task. After all, managing finances or crunching numbers may not be your forte at all!

Fortunately, keeping a tab on a few financial metrics, such as the Days Sales Outstanding ratio, can help you stay afloat.

This post discusses everything you need to know about Days Sales Outstanding, its formula, and calculation. Let’s get started.

Key Takeaways

• Definition: Days sales outstanding (DSO) measures the average number of days it takes for a company to collect payment after a sale.
• High DSO: Indicates delays in receiving payments, leading to potential cash flow problems.
• Low DSO: Shows that payments are received quickly, which can be reinvested into the business effectively.
• Benchmark: A DSO under 45 days is generally considered low.

What is Days Sales Outstanding (DSO)?

Every sale generates revenue. But except for certain industries, like retail or hospitality, which accept immediate transactions, the trade or sale often takes place with the raising of invoices. These invoices contain a detailed list of the goods and services, their per-unit cost, total quantity, and the final charge.

However, merely forwarding the invoices to your customers is not enough. Your business also has to collect the payments against them.

The payment collection depends on your business's collection model and your client's payment system (governed by the vetting of invoices, mode of payment, frequency of payment, etc.) These complexities may introduce delays in settling these invoices, which is where Days Sales Outstanding enters the picture.

Days Sales Outstanding calculates the average number of days taken to collect payments against credit sales. It is worth clarifying here that credit sales are sales that one settles at a future date after the product is delivered or service is rendered.

What Purpose of DSO

• Operational Effectiveness: Analyzes how efficiently a company manages its receivables.
• Identifying Bad Debts: Helps in identifying and managing bad debts.
• Cash Flow Management: Crucial for small and medium enterprises to avoid cash flow issues.

What Does Days Sales Outstanding Mean to Your Business? And What Causes it to Fluctuate?

DSO calculation helps you identify the systemic procedural issues plaguing your business' cash flow. You can use it as a compass to carry out corrective action and streamline the collections process.

Given that DSO is a variable metric, it may also highlight certain trends surrounding your organization.

For example, higher DSO values signal that you are selling to customers who are less likely to settle their invoices. And even though such a practice may get your sales figures skyrocketing, it will have negative repercussions in the future. In contrast, lower DSO values allow businesses to collect more revenue, which is reinvested in the company’s growth.

On other occasions, a client may withhold payment for seemingly justifiable reasons, say, they are unhappy with the quality or the invoice is not adding up. In such instances, businesses must review their internal processes to address such problems.

While conducting an internal inquiry into the matter, it's essential to request payments for the undisputed sections of the invoice to keep the cash flowing.

Delayed accounts receivable may even be an indication that your collections process is inflexible or not very customer-friendly, which restricts their options. Accordingly, you may have to diversify your payment options to collect them on time.

On that note, the correlation between DSO and Cash Conversion Cycle (CCC) requires special mention. The CCC is a reflection of the monetary value generated for every dollar invested in the business. Therefore, it takes into account elements like the time taken to manufacture products, sell inventory, collect accounts receivable, and pay accounts payable. Naturally, DSO plays a key role in determining a holistic understanding of the CCC.

As a result, DSO and CCC work complementarily, with the former giving an overview of the collections process and the latter deconstructing the business processes at large.

Days Sales Outstanding vs. Average Collection Period

DSO measures the average number of days it takes to collect payments after a sale is made. It provides a snapshot of the efficiency of a company’s credit and collections process.

Average Collection Period also measures the time it takes to collect receivables, but it is often calculated using a different methodology. While DSO is typically calculated over a specific period (e.g., monthly, quarterly), the Average Collection Period might take a broader view of the collection process. Both metrics aim to provide insights into how well a company is managing its receivables, but they might be used differently depending on the specific needs and context of the business.

Days Sales Outstanding Formula

Before diving into the Days Sales Outstanding formula, let’s briefly go over the key terminologies involved while making the calculation.

• Accounts Receivable: This is an accounting term referring to all the outstanding payments owed to your business for a given time. You can access this information through your income statement or balance sheet.
• Credit Sales/Net Sales: This reflects the total revenue generated by the business, minus any returns, discounts, or allowances. You can find this value in your income statement.
• Number of Days: The period across which you are carrying out the DSO calculation.

Now that you are acquainted with the jargon, let’s proceed with the DSO formula. Here’s what it looks like:

DSO = Average A/R / Total Credit Sales (Number of Days)

A low DSO value indicates that the company collects its account receivables frequently. Conversely, a high DSO corresponds to greater latency between credit sales and payment collection.

Let’s gain a more holistic understanding of the concept through a working example.

Problem Statement

Yo-han Kim owns a business. His income sheet reflects USD 25,000 as accounts receivable (A/R) on April 1st, 2020. By May 1st, 2020, the amount shifts to USD 20,000. During this period, Yo-han also makes credit sales worth USD 45,000.

DSO Calculation

First, he calculates the average accounts receivable.

Average A/R = (20,000 + 25,000) / 2 = USD 22,500

As mentioned in the problem statement, the total credit sales for the period is USD 45,000.

Further, April has 30 days. Hence, the number of days is 30.

He then refers to the DSO formula:

DSO = Average A/R / Total Credit Sales (Number of Days)

And performs DSO calculation:

DSO = $22,500 / $45,000 (30)

At this rate, Yo-han figures out that for the given period, it takes him 15 days to collect credit sales.

So, what else can one extract from the DSO value? The next section examines its relevance.

Days Sales Outstanding Benchmarks Across Industries

According to the National Summary of Domestic Trade Receivables, DSO typically averages around 31-32, which is considered excellent. However, the value is subject to various factors, with the industry where the business operates playing one of the most crucial roles.

For instance, a DSO of 110 days could spell doom for food manufacturers, while it is the norm for the oil sector.

Hence, to gain a realistic perspective on your business through DSO, you need to consider the average expectations prevalent in your industry. As of 2020, here are the industry-wide averages of the Days Sales Outstanding that you can use as a benchmark:

• Retail: 25 days
• Manufacturing: 45 days
• Oil & Gas: 110 days

In addition to these industry standards, you must also refer to your competitor’s DSO and the terms they employ to improve DSO.

If your DSO ratio needs some improvements, you can make a few minor changes to your collection process to pull it down to normal values. Here are a few tips to improve DSO:

• Wherever possible and applicable, collect payments from your customers upfront.
• Offer multiple payment options for your products and services to offer your customers greater convenience.
• Introduce automation for payment collections, especially in cases of recurring and online payments.
• Reconsider your credit sale practices and payment terms.
• Carry out negotiations with your customers to identify an amicable and comfortable invoicing frequency.
• Offer discounts or other incentives for upfront or faster payments.
• It is best to invest in a fully functional invoicing solution to manage your invoicing.

How to Lower Days Sales Outstanding (DSO)

1. Streamline Invoicing: Send invoices promptly and ensure they are clear and accurate.
2. Implement Payment Terms: Offer incentives for early payments and set clear payment terms.
3. Improve Follow-Up: Regularly follow up on overdue accounts.
4. Use Technology: Implement automated invoicing and payment tracking systems.
5. Customer Credit Management: Evaluate the creditworthiness of customers before extending credit.

What are the Applications of Days Sales Outstanding?

• Performance Analysis: Used to assess the efficiency of a company’s credit and collection efforts.
• Financial Planning: Helps in forecasting cash flows and planning working capital needs.

What are Good and Bad DSO Numbers?

Good DSO: Generally Under 45 Days

• Efficiency in Collections: A DSO under 45 days typically indicates that a company is efficient in collecting its receivables. This means that the business receives payments from its customers quickly, reducing the waiting time between the sale and receiving the payment.
• Positive Cash Flow: Lower DSO values contribute to better cash flow management. The quicker inflow of cash allows the company to reinvest in operations, pay off liabilities, and take advantage of growth opportunities without relying heavily on external financing.
• Customer Quality: A low DSO can also reflect a high-quality customer base that pays on time. This could be due to good credit management practices, robust invoicing processes, or strong relationships with customers.
• Financial Stability: Companies with lower DSO are often seen as more financially stable by investors and creditors because they have a steady flow of cash and are less likely to face liquidity issues.

Bad DSO: Indicates Delays in Payment Collection and Potential Cash Flow Issues

• Delayed Payments: A high DSO suggests that a company is facing delays in collecting payments from customers. This delay can be due to several reasons, such as ineffective collection processes, poor customer credit quality, or lenient payment terms.
• Cash Flow Problems: High DSO values can lead to cash flow problems. When receivables take too long to convert into cash, the company may struggle to meet its short-term liabilities and operational expenses. This situation may force the company to rely on external borrowing, increasing financial costs and risk.
• Indicator of Poor Practices: Persistent high DSO can indicate deeper systemic issues within the company’s credit policies, customer relationship management, or invoicing and collection processes. It could reflect ineffective management practices that need to be addressed.
• Risk of Bad Debts: The longer receivables remain unpaid, the higher the risk of them turning into bad debts. This not only affects the company's revenue but also its profitability, as it may need to write off uncollectible accounts.
• Impact on Growth: Companies with high DSO may find it challenging to invest in growth opportunities. The lack of readily available cash can limit the ability to purchase inventory, expand operations, or invest in new projects, thus stunting growth.

Factors Influencing DSO?

• Payment Terms: The credit terms agreed upon with customers significantly impact DSO. Shorter payment terms typically result in lower DSO.
• Customer Base: The creditworthiness and payment behavior of customers play a crucial role. Reliable customers with good payment histories contribute to lower DSO.
• Collection Practices: Efficient and proactive collection practices, such as timely invoicing and regular follow-ups, help in maintaining a lower DSO.
• Economic Conditions: Broader economic conditions can affect customers' ability to pay on time, thus impacting DSO.

Common Instances Where Organizations Misinterpret Days Sales Outstanding

1. Without Knowing Payment Terms: DSO should be interpreted with the company's payment terms in mind. For example, a DSO of 60 days might seem high if the standard payment term is 30 days but is quite efficient if the term is 90 days. Understanding the agreed payment terms helps in accurately assessing the efficiency of the collections process.

2. Without Sales Information: Accurate sales data is crucial for calculating DSO. Ignoring sales fluctuations, especially towards the end of a period, can mislead. For instance, a spike in sales can lower DSO temporarily, giving a false sense of efficient collections. Regular tracking of sales data ensures accurate DSO calculations.

3. Without Monitoring Invoicing Process: Timely and accurate invoicing is essential for realistic DSO calculations. Delays or errors in invoicing can inflate DSO values. Regular reviews and audits of the invoicing process can help identify and rectify issues, leading to more accurate DSO figures.

Metrics to Analyze Along With Days Sales Outstanding (DSO)

1. Accounts Receivable Turnover: This metric shows how often receivables are collected during a period. A higher turnover rate indicates efficient collections and lower risk of bad debts, complementing DSO by providing insights into the frequency of collections.

2. Average Collection Period: Similar to DSO, this metric indicates the average time to collect receivables, providing a broader view of collection efficiency. It helps businesses understand the typical timeframe for converting receivables into cash.

3. Cash Conversion Cycle (CCC): CCC measures the overall efficiency of a company’s cash flow, including the time taken to sell inventory, collect receivables, and pay suppliers. DSO is a critical component of CCC, and faster collections can significantly improve the CCC, enhancing financial health.

CCC includes three components:

• Days Inventory Outstanding (DIO): Time taken to sell inventory.
• Days Sales Outstanding (DSO): Time taken to collect receivables.
• Days Payable Outstanding (DPO): Time taken to pay suppliers.

A shorter CCC indicates a more efficient operation, as the company can quickly turn its investments into cash. DSO plays a critical role in this cycle, as faster collections can significantly improve the CCC, enhancing overall financial health.

Conclusion

Days Sales Outstanding is a crucial factor that may bear implications on your business’ growth. You must calculate DSO frequently and monitor the changes to know which way your business is heading. This small consideration can help you stay ahead of any potential roadblocks in your business’s growth!

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FAQs:

What is the difference between DSO and AR?

• DSO: Measures the average number of days to collect receivables.
• AR: Represents the total amount of money owed to the company by its customers.

How do you calculate DSO days in Excel?

• Formula: (Accounts Receivable / Total Credit Sales) × Number of Days
• Steps: Sum your accounts receivable, divide by total credit sales, and multiply by the number of days in the period.

What is the average DSO by industry?

Industry Benchmarking: Varies widely; for example, utilities typically have a lower DSO compared to construction.

Is days sales outstanding the same as receivables turnover?

No, Receivables turnover is the number of times receivables are collected during a period, while DSO is the average number of days to collect receivables.

What is the DSO ratio?

Indicates the average time taken to collect payments and is calculated using the formula mentioned above.

What is DSO in KPI?

Used to measure the efficiency of a company’s credit and collections process.

How do you read a DSO?

Interpretation: A lower DSO indicates quicker payment collection, while a higher DSO suggests delays.

What is the formula for DSO working capital?

DSO Formula: (Accounts Receivable / Total Credit Sales) × Number of Days