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"Days Sales Outstanding” Meaning: Understanding DSO

Topics: Finance, Management

Days Credit Sales Outstanding or DSO for short, measures the average number of days it takes to get paid from your accounts receivables. It's a measure of a company's collection efficiency.

Extending credit to your small and medium-sized business customers is almost a requirement for any business. Days sales outstanding can help measure performance on these credit sales.

Days Sales Outstanding Meaning: Understanding the Impact

Determining DSO doesn't necessarily lead to a good or bad number. DSO is an average, and needs context to fully understand its impact on a business. Let's look at a few scenarios of credit management DSO.

A high DSO means it is taking longer to collect from customers, while a lower DSO means the business is collecting quicker. It might initially appear that a high DSO should be avoided. But if you are offering better credit terms to customers, a higher DSO can lead to more sales.

How does a higher DSO negatively impact a business? If better credit terms aren't being extended to customers but customers are still taking longer to pay, this means the business isn't generating cash flow in a timely manner. Risk of insolvency increases the longer this scenario goes on

A low DSO, below the industry average, for example, can mean the business has a cautious or aggressive collection policy. While the business is receiving payments quicker, it can also be limiting its sales capacity. Some potential customers may not be able to adapt to such a credit policy.

A lower DSO can also occur if the business is offering early payment discounts.

The next question to ask might be: What is a good DSO ratio for your enterprise?  To determine the answer, measure against some benchmark. This benchmark can be competitors or an industry standard.

In some cases, you'll have business customers who pay late and even those who don't pay. The latter is more of a legal issue with debt collection. Customers taking longer to pay will increase DSO. Too many late payers may signify that its time to revisit the credit sales collection policy.

How to Lower DSO

Lowering your DSO means you'll be paid quicker. There is a limit to how much you can lower your DSO, though.

If DSO is 60, for example, 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 factors should be considered:

  • Are invoice terms clearly stated and due dates specified?
  • Are there any penalties or fees stated for overdue invoices?
  • Are customers provided with 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 regarding your credit policy.

From that point on, you and your customers will be very clear on your credit policy.

Discovering DSO Problems Through Trends

To understand DSO, it's better to look at it over several weeks or even months in a graphical form. This allows your company to see a trend. If DSO is increasing every month, it could point to a problem collecting receivables from customers. 

Example Calculations

The formula for days sales outstanding is: 

    (Accounts receivable ÷ Net credit sales) × Number of days in a year

The number of days in a year can be 365 or 360. Net credit sales may not be displayed on any financial statement. The company's accounting department should be able to produce the necessary numbers.

If a business has $15000 in accounts receivable and $90000 in credit sales (sales not yet collected), this means it will have a DSO of:

    15000/90000 * 365 = 60.83

If the collection policy is 30 days, you can see a red flag going up already since its actually taking double the period of time to collect on credit sales.

There is a hidden cost in allowing DSO to significantly go over the credit policy on days to collect. Cash is basically being withheld from the business. Overall cash flow health is decreasing. There is likely a high opportunity cost for having cash locked up in credit sales.

Depending on the late fee policy, customers can be taking advantage of the business by getting a better deal to hold out over the stated collection days.

What is Your DSO Telling You?

With a better understanding of the meaning of days sales outstanding and how it impacts a large enterprise, what is your DSO number compared to your industry and competitors? 

You now have the knowledge to interpret the days sales outstanding ratio and a few directions for improving it. 

If DSO is high, you might consider taking another look at your collections policy and being more aggressive with its enforcement. If DSO is low, it could mean you are being too aggressive and scaring away sales.

Credit management DSO is a useful tool in the financial management of any business. But it can't be taken in isolation, as we've seen here. It is only one tool in a very large financial management toolbox.

Are you a B2B company that wants to improve the financial management of your business?  Find out how to automate credit management, optimize DSO, and mitigate risk when extending credit to new customers with Apruve. With Apruve, you can easily extend risk-free credit to your customers worldwide, and make sure you get paid within days. Learn more about Apruve's credit network or contact Apruve’s specialists to sign up for a demo today!

 

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