Days sales outstanding (also called DSO for short) is an average of how long invoices remain unpaid. In his book, 'Invest Like A Guru', Charlie Tian describes DSO this way, "...measures how quickly the company can get paid after delivering its products." The number by itself isn't bad or good. But once put into context, it reveals much about your accounts receivable management.
mmIf DSO is getting larger, that means it is taking longer and longer for your company to collect on payments. This could be due to a conscious decision by the company to allow longer payment times. It could also be that customers are simply taking longer to pay for no reason. In that case, it's important to investigate why.
In general and all else being equal, DSO should be a predictable number that changes little over time. If it increases when it shouldn't, it's time to investigate. If it decreases for no reason, you might want to consider shorter invoice terms (net 30 instead of net 45 for example).
Calculating Days Sales Outstanding
DSO is an average based on the number of days it takes a company to get paid after invoicing. It can be estimated using monthly, quarterly or annual numbers.
The following formula from investopia.com displays how to calculate DSO:
Either formula will result in the same outcome. We can see there are three numbers needed to calculate DSO:
- Amount of accounts receivable
- Average number of days outstanding for invoices
- Total credit sales
The above is calculated across one of the time frames previously mentioned. Let's use some real numbers to calculate DSO over a period of 30 days:
- A/R = $200,000
- Days outstanding = 30
- Total credit sales = $275,000
200,000/275,000 x 31 = .72 x 30 = 21.6
Let's break down this calculation, so we fully understand the numbers used. Accounts Receivable is an asset that shows up on the balance sheet. It is the total amount of outstanding money owed by customers. Total credit sales
Days outstanding is the period being used. In this case, it is 30 days. A/R and total credit sales are also restricted to those amounts relevant to the same 30 days.
After calculating DSO, we get a number of 21.6. If we had used values spanning a year, the number would likely be different.
Tracking And Related Cost of Managing DSO
Tim Berry, president and founder of Palo Alto Software said it best, “You can be profitable and still be bankrupt. You must closely plan and monitor your cash flow to be successful and stay in business.”
DSO is closely related to cash flow and for that reason, keeping track of your DSO is essential. When you plot DSO across a period, you can see if DSO is fluctuating within a small or broad range, overall increasing or decreasing. From this plot, you'll know which action to take, assuming you need to take any at all.
There are of course cost to tracking DSO. Someone has to run the numbers each month. There will be various types of paperwork involved. This takes away from resources that could be doing another task, which is an opportunity cost that must be considered.
There are also other costs that impact the bottom line. If your DSO is 90 days when it should be 60, you're draining money from the company. That money could be put to work on projects that will grow the company. It could also go into an interest-bearing account.
For example, let's assume you have access to an account that can earn 5% interest. To figure out the amount of interest you could earn on outstanding invoices, calculate the interest per day on total receivables and multiply it by the average number of days it takes to collect on credit sales (DSO):
((annual credit sales x interest rate) / (365 days) x DSO
To use some real numbers:
$2,200,000 x .05 / 365 x 21.6 = 110,000/365 x 21.6 = $6509.59
This means it cost the company $6,509.59 every 21.6 days (or $110,012.07 annually) to provide customers with $2.2 million in credit.
How To Lower Days Sales Outstanding
Lowering your DSO means you'll be paid quicker. There is a limit to how much you can lower your DSO.
It's important to understand what the average DSO is in your industry.
If DSO is 60, you will likely have net 60 or maybe even net 45 payment terms. Customers within the same industry will also expect such terms. This means trying to lower DSO can be a losing battle since you may begin losing customers to competitors with more industry standard terms.
If DSO is much higher than 60, say 75 or 90, those are numbers you can work with. If your terms are net 60 and customers are taking 80 days to pay, you are extending them an additional 20 days worth of credit.
To lower your DSO, one place to start is your credit policy. This will include invoice terms. The following are a few things to check:
Areinvoice terms clearly stated and due date specified?
- Are there any penalties or fees stated for overdue invoices?
- Are customers provided small discounts for paying early?
- Do you state invoice terms to customers other than on the invoice (a contract or agreement)?
If your credit policy seems fine, plot your DSO. At what point did DSO start rising? Did something change in your credit policy or with employees who handle invoicing? Are employees aware of the credit policy?
If you are still at a loss as to why DSO is higher than it should be, you can always try a reset. Start calling customers with overdue invoices and also express credit terms to them. This action alone should begin bringing in late payments, lowering DSO and getting customers on the same page in regards to your credit policy.
From that point on, you and your customers will be very clear on your credit policy.
DSO is an instrumental number that can be used as another financial health monitor in your business. If you are questioning the health of your DSO, there are ways to streamline the collections and credit issuing procedures, even furthermore you can automate these processes to bring your DSO to one. Learn how below: