Understanding Days Sales Outstanding & Its Role in Optimizing A/R

What is Days Sales Outstanding (DSO)?

Day Sales Outstanding or DSO refers to the average number of days a business takes to collect its receivables after a sale. It is considered a popular metric by diverse industries to estimate their financial health. Usually, this is measured by calculating the number of days it takes to convert credit sales to cash. Let’s say the DSO of a business is 30 days, which means it has recovered its receivables or dues in 30 days.

How is DSO calculated?

While various industries follow different approaches to calculate their DSO, the simple formula to calculate the DSO is –

Example Calculation of DSO:

For instance, company A makes around $30,000 credit sales and $20,000 accounts receivables in 40 days. Now, let’s calculate its DSO.

This means company A has recovered its dues in 26.6 days and that its DSO is 26.6 days. That’s great because if a business has DSO below 45 days, it indicates a low DSO. A business with low DSO implies it has promptly-paying customers and that its cash flow is stable.

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:

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.

You can also calculate DSO using our DSO Calculator Excel Sheet Template. 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 a Critical Metric?

DSO is a critical business metric because it determines the financial situation and growth. It also signifies how good a business is at recovering its past dues. Suppose a business takes longer than 45 days; it has to streamline its collections process to convert orders to cash in fewer days.

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 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 if you learn the significant differences between a high and a low DSO. In fact, with this, you can find out more about the effectiveness of your accounts receivable processes, particularly credit and collections. Most businesses can improve DSO based on these two factors. Plus, 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.

How to Improve DSO?

From sending timely invoices and reminders to ensure your customers pay on time to keeping your payment terms short — there are a few tried-and-tested techniques to improve DSO. Nonetheless, DSO calculation should be your natural first step towards improving DSO. Based on that, you can optimize your collections and credit policies. Some of the other strategies to improve DSO are:

1. Offer discounts to early-paying customers:

Offering incentives such as discounts or coupons to early-paying customers will improve your DSO. You can use an automated platform to communicate with your customers; you can run email campaigns to share incentives and encourage early payments. Also, this 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; so your customers are clear about the penalties.

2. Analyze risky customers and strategize accordingly:

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. You can also prioritize risky customers to avoid bad debt.

3. Accept payments in your customers’ preferred payment mode:

If your payment collection mode is outdated or limited, it may pose a problem. Given the current times, most customers prefer digital payments; if you haven’t enabled them yet, it’s time for a shift. And if your customers prefer card payments, you should be able to accept them too. A word of advice: before shifting to digital payments, learn the security aspects and the costs involved in digital payment processing. It also helps you pick 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 extensive 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.

We also recommend reading this eBook with 13 proven strategies from Fortune 1000 companies on reducing DSO. It’s available for a free download.

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:

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.

What are the Other Metrics to 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 how effective the collections team and their procedures are. Acknowledged as one of the best metrics to consider along with DSO, you can interpret the order-to-cash teams’ performance.

2. Bad Debt to Sales:

Bad debt occurs when customers can’t pay their dues, and this metric shows how much amount is written off. This is measured in ratio, and if it increases with 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.

With the right tool, you can optimize the credit and collections process, thereby improving the DSO.