CFOs across the business spectrum agree – Cash is king and oxygen for any business in today’s day and age. Days Sales Outstanding, or DSO, is a metric that provides an insight into cash flow or liquidity of a business – in essence, how much cash does your company have.
Days Sales Outstanding(DSO) calculates the average number of days for a company to collect receivables after a sale has been made. It is a popular metric leveraged across different industries to assess the financial health of an organization.
While various industries follow different approaches to calculate their DSO, the simple formula to calculate the DSO is –
Days Sales Outstanding = (Accounts Receivable/Net Credit Sales)x Number of days.
Company ABC has a total Accounts Receivable of $15,000, current Accounts Receivable of $4,000, and the sales made in 30 days period on credit is $10,000.
DSO= (Total AR/Net Credit Sales)*(Number of days) = (15,000/10,000)*(30) = 45 days.
Based on the above calculation, the DSO is 45 days, which means that it takes an average of 45 days before the company ABC can collect its receivables. Generally, a DSO below 45 days is considered to be a low DSO. Still, there is no standardized benchmark to compare against – since it varies depending on the type, industry, and structure of businesses.
It is important to note that while calculating DSO, only credit sales is taken into consideration. Cash sales is considered to have a DSO of 0 since they play no role in estimating the time between a credit sale and the company’s receipt of payment.
DSO has a significant impact on the company’s financial functions. DSO is an important metric that shows companies and business owners, how good they are at collecting cash from their customers. The ratio gives insight into critical business functions such as how quickly customers are paying back, the operational liquidity of the company, the total number of sales completed in a specific time, customer relationships, and the overall performance of the accounts receivable teams.
Understanding the fundamental differences between a high and a low DSO could guide companies to get better visibility into their cash conversion cycle and the effectiveness of their Accounts Receivable processes, especially credit and collections.
A high DSO indicates an organization’s inability to collect on receivables within a specified period. Companies with inadequate collection procedures usually have higher DSO. Another reason could be a customer’s inability or unwillingness to pay back for a product or service of the company. In this case, a company fails to convert credit sales into cash and, in the worst-case scenario, might have to write off the payment as a bad debt.
A low DSO is favorable and indicates that a company is efficient and quick in collecting the cash from its customers. Companies with excellent and efficient collection procedures usually have a lower DSO. A lower DSO also helps companies avoid writing off payment as bad debt and ensures quick inflow of operational liquidity that could be used for other high-value functions.
The analysis of DSO might not be as straight-forward as it might seem. For instance – let’s assume your company has a low DSO. This could be because of two reasons –
The calculation of DSO is the first step to benchmarking against industry standards and strategizing on areas of improvement. Since credit and collections are vital areas that impact the DSO and, by extension, cash flow – optimizing collections process and credit policies could significantly reduce DSO. Let’s dive deep into some of the other strategies that could help your company reduce DSO.
One of the proven strategies to reduce DSO is to offer incentives for early payments to your customers. With an automated solution, companies could also run campaigns to drive e-adoption for payments and invoicing for a shorter cash conversion cycle. Similarly, for consistent late payments, penalties could be charged. The A/R teams should ensure that the late fee charges are mentioned in the terms and conditions so that the customers have an idea about the penalties upfront.
Customer retention is essential for steady business growth. However, if a customer is consistently delinquent, the collections team should re-evaluate their credit-worthiness and payment terms to avoid risk. Account segmentation based on payment trends and associated risk could go a long way in identifying critical, at-risk customers and tailor the collections strategy based on the risk level. The collectors should prioritize these at-risk accounts to avoid delinquency and bad-debt.
Limited payment options could restrict your customers from paying you on time. Moreover, in the current economy, the availability of payment options could make all the difference between getting paid and customer accounts going delinquent. However, while enabling digital payments could be a strategic move to get paid faster, you should ensure that you understand the security aspects and costs associated with digital payment processing.
A comprehensive order-to-cash automation could boost the effectiveness of the accounts receivables process. Investing in automation could help companies to standardize the collection processes, automate payment reminders and dunning calls, track payment status, and customize invoices according to different customers.
DSO, as a metric, leaves room for assumptions. So, it is better to analyze DSO collectively with a few other parameters. This would help the senior management to get a clearer picture of what the bottlenecks are, and what the next action item should be.
To analyze the performance of the Order-to-Cash teams, CEI is perhaps the best metric to consider along with DSO. CEI helps the senior management to understand how effectively their Collections team is performing. To know more about CEI, read our next blog.
Bad debt to Sales directly shows how much amount had to be written off as the customers were unable to pay their dues. This KPI is calculated as a ratio, and if the ratio tends to increase with time, then it reflects ineffective credit policies and management.
DDO is calculated and considered to get an idea of how the organization is dealing with its Deductions. It is calculated by dividing the outstanding deductions to the average deductions which were faced during the last three/six/twelve months.
A/R turnover ratio is a metric that specifies how efficiently an organization is collecting its assets. A higher A/R turnover ratio is recommended as it reflects a strict credit policy and efficient collections of receivables.
BPDSO is a theoretically-calculated metric that specifies the best possible number of days in which an organization could collect its receivables. The motive behind calculating BPDSO is to initiate an internal comparison between the DSO and BPDSO so that the senior management can set the right approach to benchmarking.
Companies often calculate DSO and benchmark against industry standards but get stuck in identifying the right levers to optimize their credit and collections process and, in turn, DSO. Learn more about how companies often misinterpret DSO and some key pivots in reducing DSO while enhancing A/R processes.
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