Days Sales Outstanding vs. Accounts Receivable Turnover Ratio

What is Days Sales Outstanding (DSO)?

Days sales outstanding measures how long it takes for a company to collect its receivables after a credit sale has been made. Many industries use this metric to keep track of their accounts receivables.

The formula for calculating DSO:

Explanation:
If a company ABC makes credit sales worth $50,000 and the account receivables in 20 days is $40,000, then the DSO = ( $40,000/$50,000)*20 = 16. This means that the company takes an average of 16 days to collect its receivables. This can either indicate a low or high DSO considering the company’s payment policy.

A low DSO indicates that the company collects its dues ahead of payment time. A high DSO indicates that the company takes longer to collect its dues than the credit period offered. Ideally, a lower DSO indicates better collection efficiency and a solid credit policy.

Monthly, quarterly and annual assessments of DSO give better insights into the overall performance of your company’s AR team.

What is Accounts Receivable Turnover (ART) Ratio?

Account receivable turnover (ART) ratio measures the number of times a company collects its average account receivables within a term (monthly, quarterly, annual). It is a measure of a companies’ collections efficiency. The higher the ART, the higher is the efficiency of collections.

The formula for calculating ART Ratio:

Where,
Average Accounts Receivable= (AR at the beginning of Term + AR at the end of the term)/2

Explanation:
If a company ZZZ has net credit sales worth $3,000,000 and an AR of $200,000 at the beginning of a year and $225,000 at the end of the year, then

Average AR = ($200,000+$225,000)/2 = $212,500
ART = $3,000,000/$212,500 = 14.11

This means that company ZZZ collects accounts receivables ~14 times a year.
To find the account receivable turnover in days, divide 365 by the ART ratio.

For Company ZZZ,

Receivable turnover Ratio in Days (annual ART) = 365/ 14.11 = 25.86
This means that an average customer takes ~26 days to repay the debts. If the company has a strict 30 days payment policy, this ART ratio is within the payment period. Hence, The company has a high accounts receivable turnover ratio, which is good.

What's the difference between Days Sales Outstanding and Accounts Receivable Turnover Ratio?

Why should you focus on both DSO and ART?

Here are some ways DSO and AR turnover ratio help you monitor your AR operations.

• Collections efficiency: The DSO determines how soon customers pay and the efficiency of your collections department. You can use the AR turnover ratio to see how quickly your invoices are paid.
• Cash-flow forecasting: Low DSO values indicate a better cash flow. Forecasting accounts receivable using DSO gives you a snapshot of the financial health of your business. You can plan investments based on the predicted cash inflows or re-invest the money to grow sales.
• Customer satisfaction: When you notice that your clients are paying before the due date, you can safely infer that they are satisfied with your services and would like to continue with them. You can utilize this information to give them a variety of discounts and incentives to further strengthen the relationship.
• Streamlining credit policies: A higher DSO or a lower ART is often an indication that your credit policies are not stringent and that your customers may have received undue credit limits. Thus, tracking DSO and ART helps you know when to adjust your credit policies.

Looking at both DSO and AR turnover ratio metrics collectively is crucial. Often, when analyzed in silos, these metrics can be misleading (e.g. DSO values may vary due to seasonal slumps or spikes in sales). Having another metric to cross-examine the insights helps remove errors in your judgment.

DSO and ART complement each other to give you a more rounded picture of your collections efficiency. They help strengthen credit policies to reduce bad debt. These metrics also help gauge customer experience and satisfaction.

Wrapping up

Days sales outstanding and accounts receivable turnover (ART) are both performance metrics that help determine your company’s collections process efficiency. Although they are effective alone, analyzing both together provides a complete picture of your cash inflows.

Automating the collections process with effective customer correspondence can help increase the cash flow while minimizing manual efforts. With the eInvoicing and Collections automation solution from HighRadius, you can seamlessly reduce DSO, improve ART, and increase the efficiency of your AR operations.