What is Days Sales Outstanding (DSO) in Finance and How to Calculate?

Introduction

Cash is undeniably the lifeblood of any business and maintaining a healthy cash flow is the key to keep a business thriving. In an era of heightened interest rates and economic uncertainty, maintaining a healthy cash flow has become more vital than ever.

To gain a clear understanding of cash flow and liquidity, businesses rely on a powerful metric called Days Sales Outstanding (DSO). This metric serves as a valuable indicator, revealing how effectively a company collects cash from customers who make purchases on credit. 

By measuring and analyzing DSO, businesses can attain financial clarity and optimize their cash flow management. Let’s understand the importance of DSO and how it can affect accounts receivable days.

What is Days Sales Outstanding (DSO)?

Day Sales Outstanding (DSO) is a financial metric used to measure the average number of days it takes for a company to collect payment from its customers after a sale has been made. This metric provides valuable insights into the efficiency of the company’s accounts receivable management.

Cash is undeniably the lifeblood of any business and maintaining a healthy cash flow is the key to keep a business thriving. In an era of heightened interest rates and economic uncertainty, maintaining a healthy cash flow has become more vital than ever.

To gain a clear understanding of cash flow and liquidity, businesses rely on a powerful metric called Days Sales Outstanding (DSO). This metric serves as a valuable indicator, revealing how effectively a company collects cash from customers who make purchases on credit. 

By measuring and analyzing DSO, businesses can attain financial clarity and optimize their cash flow management. Let’s understand the importance of DSO and how it can affect accounts receivable days.

How to Calculate DSO?

To calculate DSO, divide the total accounts receivable for a given period by the total credit sales for the same period, and multiply the result by the number of days in the period.

Days Sales Outstanding = (Accounts Receivable/Net Credit Sales)x Number of days.

Example Calculation of DSO:

Let’s consider a specific scenario for Company A, a hygiene products provider. In a given period, the company recorded approximately $30,000 in credit sales and had $20,000 in accounts receivables that were collected within 40 days. Let’s calculate its Days Sales Outstanding (DSO): 

DSO = (20,000 / 30,000) * 40 = 26.6 days 

This signifies that Company A successfully recovers its dues within an average of 26.6 days, resulting in a DSO of 26.6 days. This achievement is remarkable because a DSO below 45 days indicates a low DSO, reflecting the company’s benefit from promptly-paying customers and enjoying a stable cash flow.

How to Calculate Monthly DSO?

Let’s say the same company A makes $20,000 worth of credit sales in a month and receives around $16,000 as receivables.

Its monthly DSO is:

DSO= (16,000/20,000) x 30 = 24

It’s important to note that we consider only credit sales while calculating the DSO. Cash sales are said to have a DSO of 0 because they don’t affect the account receivables or the time taken to recover the dues.

How do I calculate DSO in Excel? 

It barely takes five minutes to get started, and it has some of the best DSO optimization strategies implemented by Fortune 500 companies.

Why is DSO important?

DSO is a critical business metric because it determines the financial health of a business. It signifies how good a business is at recovering its past dues. If a business takes longer than 45 days to convert orders into cash, it must streamline its collections process to expedite cash conversion.

DSO also offers insights into the following:

• Are the customers paying back on time
• The operational liquidity of the business
• The total number of sales in a certain period
• Customer payment behavior and relationships
• Overall performance of the accounts receivable teams
• Collections team’s efficiency and how to optimize payment policy and strategy

It’s easier to evaluate financial health after weighing all these factors together. Let’s explore how a low or high DSO can affect a business.

What Does a High DSO and a Low DSO Mean?

As a business, you can understand your cash conversion cycle better by learning the differences between a high and a low DSO. In fact, with this understanding, you can find out more about the effectiveness of your accounts receivable processes, particularly credit and collections. Additionally, you can significantly improve your cash flow by reducing DSO.

What is a High DSO?

In simple words, a high DSO indicates that a business takes more days to collect its dues. This could be because of two reasons — either the business lacks customers who pay on time or its collections procedure is inefficient. A business with high DSO often fails to convert orders to cash, and in some cases, it writes off the payment as a bad debt. As a result, this could lead to unstable financial health.

What is a Low DSO?

A low DSO suggests a business collects its debt within its payment time and has prompt-paying customers. It also indicates that the business has an efficient collections process and a proactive collections team. And that is what leads to a lower DSO and helps a business recover past dues seamlessly. When a business has a low DSO, it also guarantees inflow of operational liquidity that can be used for other high-value functions.

Having said that, it’s not as straightforward as it appears. Suppose company A has a low DSO. This could be because of two reasons:

• Relatively low numerator (net receivables) value: This indicates the collections team has effectively collected the dues. It’s a sign of good financial health.
• Relatively high denominator (net sales) value: Ideally, this situation occurs due to a lenient credit policy. In cases where your credit and sales team extend credit without proper risk assessment, it may display a low DSO initially. However, in due course, it results in faults or bad debts.

In general, a DSO under 45 is considered low, but it’s crucial to compare within the same industry to decide if you should work on improving it. Also, businesses need to track DSO over time and consider seasonality factors. 

How to Interpret DSO Correctly

Understanding what constitutes high or low DSO is just the beginning; now, you must interpret it by considering billing terms, benchmarking against industry standards, and more. Remember, reducing past-due receivables, minimizing bad debt, and enhancing cash inflow depend on accurate interpretation. 

Companies often misinterpret DSO, leading to inaccurate performance measurement. For medium-sized companies seeking to make the right decisions for business growth, precise DSO interpretation is essential. 

Why Interpreting DSO Correctly Is Critical for Mid-sized Businesses?

For medium-sized companies with ambitious growth goals, competing in a fiercely global marketplace demands maximum efficiency. The success or failure of these businesses often hinges on their ability to manage cash flow effectively. Unfortunately, one of the main reasons many businesses face cash flow challenges is the delay in receiving payments from customers. 

Without sufficient funds to fuel day-to-day operations, companies are at risk of collapse.

However, leaving the collection process to chance is not a viable option. Proper analysis of Days Sales Outstanding (DSO) can provide crucial visibility into a company’s performance in terms of payment collection from customers. Understanding DSO requires in-depth research on credit terms and payment trends. When assessing DSO reports, several key tactics should be considered:

• Collaborating with Credit & Sales teams to align payment terms effectively.
• Rigorously proofreading the invoicing process to minimize errors and expedite invoice delivery.
• Establishing open communication with Credit & Collections teams regarding customer payment terms and delinquent accounts.

How to Improve DSO?

Now that it’s clear that DSO can affect your AR health and it’s crucial to improve it to maintain good cash flows, let’s jump into how to improve it. Here are a few tried-and-tested DSO best practices:

1. Offer discounts to encourage early payments:

Offering incentives such as discounts or coupons to early-paying customers can help improve your DSO. You can use an automated platform to communicate with your customers and run email campaigns to share incentives, encouraging early payments. Additionally, this approach helps in proactively sending invoices. While you’re at it, ensure there’s a penalty policy for late-paying customers too. Your accounts receivable team can communicate late fee charges in the terms and conditions, ensuring your customers are clear about the penalties.

2. Regularly assess your customers’ creditworthiness

Your customers are the lifeline of your business, and to grow, you need to retain them. However, it’s crucial to understand whom you’re getting into business with. If a customer consistently delays payments, you must re-evaluate your strategy. Ensure your collections team is evaluating your customers’ creditworthiness. Based on the risk level, you can extend your credit and prioritize risky customers to avoid bad debt.

3. Give multiple payment options to your customers:

Your customers are not all the same, and their payment preferences differ too. Offering a range of payment methods allows businesses to accommodate these preferences. By providing flexibility in payment options, you not only ease the payment process for customers but also enhance their overall experience. However, before implementing multiple payment options, it’s essential to consider security aspects, associated costs, and choose the right payment gateway system.

4. Invest in an automated system:

An automated platform can streamline your credit and collections further. If you go for an advanced order-to-cash automation tool, it can enhance your accounts receivables process. Besides, with automation, you can automate payment reminders, formalize collection processes, monitor payment status, and customize invoices for every customer.

How to Reduce DSO?

Do you know that even small reductions in DSO can yield substantial improvements in a business’s financial health? To enhance cash flow and achieve optimal financial performance, consider implementing these DSO reduction strategies.

1. Establish clear credit policies: Develop well-defined credit policies that outline credit terms, payment deadlines, and consequences for late payments. Transparent policies can encourage customers to adhere to payment schedules, positively impacting DSO.
2. Offer partial payments for large invoices: For substantial invoices, consider offering customers the option to make partial payments. This approach can make settling bills more manageable for customers and reduce the overall DSO period.
3. Collaborate with sales team: Foster collaboration between the sales and finance teams to ensure timely invoicing and prompt follow-ups. A united effort can lead to better cash flow and a reduced DSO.

While these tips can certainly help improve DSO, businesses must also pay close attention to these instances to avoid any possible misinterpretation of DSO.

Common Instances Where Organizations Misinterpret DSO?

Understanding and effectively utilizing DSO is critical for credit and collections managers to plan their next action items. However, senior management, particularly in medium-sized businesses, often overlooks opportunities to leverage DSO for optimizing their business processes. Here’re some common use-cases where organizations misinterpret DSO, hindering their potential for improvement and growth.

1. Judging DSO Without Knowing the Payment Terms

From the graph, it is evident that the DSO of Colgate is 34.09, and the DSO of P&G is 25.15. Does this mean that Colgate has a scope of improvement in collecting its receivables? This might not be true because we are not aware of Colgate’s payment terms. If the payment term of Colgate is 30 days, then there is scope for improvement, while if the payment term is 60 days, then we could say that their Collections efforts are in the right place.

2. Judging DSO Without Gathering Information from Sales

As we know, DSO is also influenced by Sales teams. The following two examples support this statement:

• Customers tend to delay their payments during a fiscal year-end. If the Sales teams close a deal towards the end of a month and expect the customers to pay on time during a financial close, it would instead lead to an increased DSO count.
• Influenced by the competitor’s activities, if the Sales teams offer an extended payment term to their customers, this is often viewed as an opportunity to secure more revenue. However, this leads to increased DSO.

This is why before jumping to a conclusion, the Credit and Collections teams should have a knowledge transfer with Sales teams.

3. Judging DSO Without Monitoring Your Invoicing Process

Unpaid invoices can be a source of stress for any business, and dealing with them can be painful. Several reasons could contribute to customers not paying on time, such as lost bills or incorrect pricing. Errors in the invoicing process can also raise customer suspicions about your business practices, potentially undermining the customer experience and leading to an increase in DSO. Therefore, it's crucial to monitor your invoicing process to prevent misjudging DSO.

Companies need to do a customer-wise analysis of invoice acknowledgment. This would help them understand whether the customers have received their invoices on time or not. DSO evaluation should be dissected based on faulty invoices, late invoices to have more insights. To have better tracking of billing & invoicing, organizations should resort to EIPP.

A wrong approach to judge DSO could lead to the setting of unrealistic targets by senior management. For example, while undertaking digital automation projects, you might end up setting wrong DSO targets in the ROI calculation. This would result in an improper action plan which might be counter-productive for the organization’s A/R operations.

How to Forecast Accounts Receivable Using DSO?

Forecasting Accounts receivables helps in predicting future payments and cash flow. This is usually quantified by analyzing your customers’ payment history.

You can easily forecast your accounts receivable using DSO. Here’s how

• Sales Forecast: Begin with forecasting your sales, and you can determine this by examining your past month’s sales. While forecasting this, you may want to consider various factors like customer retention or attrition, signing up new customers, economy, price changes, etc.
• Calculate Days Sales Outstanding: We’ve already discussed the DSO calculation formula; using that, you can calculate your DSO and figure out how long your customers take to fulfill payments.
• Forecast Accounts Receivable: Now that we have the sales forecast and DSO calculation, we can forecast accounts receivable. The formula to calculate accounts receivable forecast is:

Accounts Receivable Forecast = Days Sales Outstanding x (Sales Forecast/Time)

Let’s say company A has a sales forecast of around $20,000 in 30 days, and DSO is 20.

Now, Accounts Receivable Forecast = 20 x (20,000/30)

It’s around $13,333.

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Metrics You Should Analyze along with the DSO?

While DSO calculations help optimize A/R, they still leave room for assumptions. That’s why it’s best to consider other factors for a clear picture. Besides, these factors help the senior management detect error-prone areas and formulate an action plan to eliminate them.

1. Collections Effectiveness Index (CEI):

As the name suggests, CEI measures the effectiveness of the collections team and their procedures. Recognized as one of the best metrics to complement DSO, it provides valuable insights into the performance of the order-to-cash teams.

2. Bad Debt to Sales:

Bad debt occurs when customers can’t pay their dues, and this ratio measures the amount of money a company needs to write off as a bad debt expense compared to its net sales. If this ratio increases over time, it suggests weak credit policies and management.

3. Days Deduction Outstanding:

DDO or Days Deduction Outstanding is a metric calculated to clarify how a business deals with its deductions. DDO is calculated by dividing the outstanding deductions by the average deductions in a certain period. The period could be three, six, or 12 months.

4. Accounts Receivable Turnover Ratio:

A crucial metric to gauge how a business manages and collects its assets. We recommend aiming for a high A/R turnover ratio as it indicates process efficiency.

5. Best Possible Days Sales Outstanding:

This metric defines the best possible number of days it takes for a business to collect its receivables. It’s theoretically calculated for an internal comparison between the DSO and BPDSO. Based on this, the senior management establishes the best method for benchmarking A/R.

Let’s take a real-world example of how Apple strategically sustains a negative cash conversion cycle, setting it apart from competitors like Samsung. This is intriguingly driven by Apple’s low DSO and a long DPO. For a detailed analysis of how these dynamics play out in the tech industry, check out Apple’s story.

Wrapping Up

When addressing DSO, it’s crucial to examine the complete picture. Consider factors such as payment processing times, customer creditworthiness, and the efficiency of your invoicing and collections processes. By analyzing these key elements and ensuring they align harmoniously, you may reveal insights that can help you identify and address DSO-related challenges effectively, leading to improved cash flow and enhanced financial stability.

Also, to improve DSO, start leveraging the right tools – with the right tool, you can optimize the credit and collections process, thereby improving the DSO.

Ready to give it a shot? The Integrated Receivables Cloud Platform from HighRadius is an industry-trusted credit and collections platform. Powered by AI, you can seamlessly reduce DSO with Collections automation.