DSO stands for days sales outstanding. DSO is a measure of the number of days it takes accounts receivable to collect cash from outstanding invoices. In other words, how quickly are customers paying their invoices on average? DSO doesn't measure against one customer. Instead, it takes the measure of all outstanding invoices.
DSO is calculated using the following simple formula:
(Ending Total Receivables / Total Credit Sales) x Number of Days in Period
As an example, let's say total receivables for the second quarter were $10,000 and total credit sales were $18,000. The second quarter had 91 days. The calculation is as follows: ($10,000 / $18,000) x 91 = 50.5 days DSO. This means it takes 50.5 days on average to convert accounts receivable into cash. Ending Total Receivables is the accounts receivable balance. Total Credit Sales is the dollar value of outstanding invoices.
When choosing a period (i.e., Number of Days in Period) to calculate DSO, it's important to choose a meaningful sample size. One month may not be enough. Quarterly and annually usually work well. Quarterly is for shorter time frames. For example, what does the recent DSO trend look like? This can tell you if recent efforts to improve DSO are working. Annual periods can be done in addition to quarterly. Annual periods allow you to see long-term trends in DSO.
What is a good DSO? This will depend on other companies within the same industry. To get an idea of overall DSO across many industries, CFO Magazine reported on a survey conducted by APQC that showed DSO across three groups:
- Top performers: 30
- Median: 36
- Bottom performers: 48
Keep in mind that you're better to focus on your specific industry's numbers.
Is a high DSO bad? If your competitors have lower DSOs, then yes - a high DSO can signify an issue with your collection process. For some industries, a high DSO is a part of doing business in that industry. Sageworks has identified 10 industrieswith DSOs ranging from 66 to 125 days:
- Management of Companies And Enterprise: 125.07
- Oil and Gas Extraction: 110.86
- Technical and Trade Schools: 109.32 Days
- Automotive Equipment Rental and Leasing: 104.35
- Outpatient Care Centers: 98.99
- Support Activities for Mining: 90.76
- Architectural, Engineering, and Related Services: 74.36
- Scientific Research And Development Services: 70.75
- Foundation, Structure, And Building Exterior Contracting: 67.46
- Other Heavy and Civil Engineering Construction: 66.51
Sageworks reported that average DSO among private companies is 39, which is not too far from APQC’s median of 39. Sageworks also noted that average private company accounts receivable days for the past five years had averaged 35 to 40 days.
What can a high DSO vs. a low DSO say about a company's accounts receivable collections practices? A high DSO, especially one that is trending up, shows that a company is taking a long time collecting its receivables and the process is not getting any better. The company can't use cash that is tied up in its receivables. In this scenario, it's not uncommon for working capital to decrease more rapidly than cash is coming in, leading to a cash flow crunch. Also, if you have to send some invoices to collection agencies, that will add more time to your DSO.
A low DSO means the company's collection policy may be too stringent. In fact, the company may be unknowingly turning away customers because of its credit policy.
Tracking DSO Performance
DSO should be part of any KPI (Key Performance Indicator) dashboard. DSO shows your receivable's efficiency. Tracking DSO over time will reveal a trend. You can track both quarterly and annual DSO. Quarterly DSO will show a change in trend much faster than annual tracking. However, it's important to track both so you can see what short-term and long-term trends are doing.
You can track DSO manually through spreadsheets. Your accounting software may even offer reports that graph DSO trends.
How To Improve DSO
Improving DSO is all about improving your credit and collections policies. If you recognize that you have a high DSO and want to bring it down, there are a few things try. One method is to start calling customers who are late with their payments. These calls should be regular with multiple calls going to each customer. You don't want to harass customers since that is illegal. You want to remind them instead that they have an overdue payment. Mention that a late penalty will be incurred if they don't pay by X date. You can also say that the last incurred late fee will be removed if they pay now over the phone.
One problem companies run into when calling customers is that they don't have enough staff to make all of the needed calls. If you have a lot of outstanding, overdue invoices to collect on, you're basically running a collections service. You'd do better to outsource your collection efforts.
Another issue is that you may be tailoring to the customer instead of what's best for your company. If the average DSO in your industry is 45 days and your DSO is 60, are you able to justify financing customers for 15 days? If you have higher sales because customers are given longer to pay, then everything may be fine. But if you are having a difficult time paying suppliers because you're always short on cash, then it's time to rethink net terms for invoices.
Of course, you can imply different ways to improve DSO or go straight to the heart of the matter - your customers. Yes - call each customer that is overdue and ask them why they haven't paid. A conversational, polite approach may yield some amazing results. For example, the invoice may lack specific details, which may put more work onto the customer. In that case, the customer has no incentive to pay early or on-time. Is the invoice being sent to the wrong person and getting shuffled around? There could be a number of customer-side factors that are coming into play, which you might not have thought about.
Finally, you can improve DSO by automating your accounts receivable. Automation removes much of the human intervention and errors that go along with it. The end result is a great improvement in efficiency and reduction in costs.
- DSO is a calculation of the number of days a company takes to collect payment from outstanding invoices.
- A good DSO depends on the industry average and compared with the other companies in the same industry.
- Automating your accounts receivable can be a great way to improve your cash flow and lower your DSO.