3 Easy Steps To Forecast Accounts Receivable Using DSO

Introduction

Forecasting accounts receivable can be challenging since payment terms are often agreed upon but not followed through. Accounts receivable forecasting is a strenuous yet necessary task for a company’s growth.
Here’s a complete guide for forecasting accounts receivable using Days Sales Outstanding (DSO). In this guide, you will learn the three essential steps to forecasting accounts receivables accurately:

1. Perform sales forecast
2. Calculate Days Sales Outstanding (DSO)
3. Forecasting and projecting accounts receivable, and a lot more.

Before diving deep into the steps involved in forecasting, let’s look at what is forecasting accounts receivable and its importance.

What is forecasting accounts receivable and its importance

Source: Gartner Finance Research (July 2021)

Accounts receivable forecasting is an essential financial analysis technique that allows businesses to predict and plan for future customer payments. By analyzing past sales data and customer payment history, businesses can forecast their future accounts receivable balance and plan accordingly.

For a business, cash flow is the most crucial element, and accounts receivable is a vital spark for the cash flow of a business. Accounts Receivable forecasting is critical to estimate the profitability of a company. It gives clarity over the business’s cash inflow to the CFO. Here are some essential benefits of forecasting accounts receivable:

• Helps to develop effective business decisions by predicting future cash flow
• Provides an accurate and reliable balance sheet to improve working capital
• Facilitates to eliminate external funding options to boost cash flow
• Utilizes financial data to help make informed business decisions
• Assists investors with a better vision of a company’s overall financial stability and liquidity
• Supports in reducing bad debts and provides a track of business debtors

To make the best financial decisions, the CFO’s office has to be on top of the information flow at all times, and forecasting accounts receivable plays a significant role. Let’s understand the step-by-step process of forecasting accounts receivable using DSO.

Steps to forecast accounts receivable using DSO

Forecasting accounts receivable would help provide ease to the CFO to predict future payments and cash flow. The easiest and most accurate way to forecast accounts receivable is by using the metric DSO. Here’s how:

Step 1: Perform sales forecast

Begin by forecasting your sales, i.e., the expected sales revenue over a certain period. Examining the past month’s sales and analyzing changes in financial data is one of the best ways to forecast sales accurately. Here are some key aspects that might change over time and need to be considered for sales forecasting:

• Signing up new customers
• Price changes
• Economy
• Customer retention or attrition
• Market growth, etc.

Although these factors might take some time to execute, they are the fundamentals of an accurate forecast. Alternative methods could also be used to forecast sales, such as historical data, deal stages, and a custom forecast model with lead scoring and multiple variables. Here’s a common formula for forecasting sales:

Example:
Assume that last month, monthly recurring revenue was $100,000, and sales revenue has grown 10% every month for the past 12 months. Also, the monthly churn has been 1% for the same period. So, for next month,
Sales forecast = $100,000+(10% x $100,000)-(1% x $100,000)= $109,000

Step 2: Calculate Days Sales Outstanding (DSO)

Days Sales Outstanding (DSO) may be defined as the average number of days a company takes to recover its receivables after a sale. Irrespective of your industry, it is the most popular metric for estimating the financial health of a business. For a CFO, it is better to keep DSO as low as possible. Different industries have different approaches towards DSO calculation but, the common formula is:

Example:
Let’s assume there is a company X whose net credit sale is around $100,000 and for 50 days accounts receivable is $60,000. Now let’s calculate its DSO,

DSO = (Accounts Receivable / Net Credit Sales) x Number of Days
=(60000/100000) x 50
=30 Days
From the above calculation, we could say that company X recovers its dues within 30 days, and hence its DSO is 30 days. Generally, a DSO of less than 45 days indicates low DSO, which means the company has consistent cash flow and fast-paying customers.

Step 3: Forecast accounts receivable

After forecasting sales and calculating DSO, we get the necessary numbers to estimate accounts receivable. The formula to calculate accounts receivable forecast is:

Example:
Let’s continue the example from Step 2 and assume that company X has a sales forecast of around $40,000 in 60 days, and as we know, DSO is 30 days. Now let’s find out the accounts receivable forecast,
Accounts Receivable Forecast = Days Sales Outstanding x (Sales Forecast/Time)
=30 x (40000/60)
=$20.000

Now It’s Your Turn

When you forecast accounts receivable using DSO, it gives you a clear picture of the financial health of your business. But always expect the unexpected while forecasting accounts receivable. Because there will always be some possibilities that must be considered, such as prepaid or delinquent clients in bills. So now it’s your turn; begin with the available data and take accounts with deviation in the payment cycle into consideration.

According to Pymnts and American Express, firms relying on manual processes take 67% more time to follow-up on overdue than those using AR automation. HighRadius helps CFOs forecast accounts receivable accurately with its e-invoicing and collections app. The AI-powered solution provides a 360-degree view of financial data and improves financial health by reducing DSO and bad debts. Request for a demo to learn more about how you can transform your accounts receivable strategy with HighRadius.

FAQ

What is Forecasting Collections in Accounts Receivable?

Forecasting collections in accounts receivable (AR) is a crucial aspect of financial management as it allows organizations to predict the timing and amount of cash inflows from outstanding invoices. This helps organizations optimize cash flow, manage working capital, and make informed business decisions.