Finance management is an integral part of business growth management. After all sales and marketing efforts to convert a prospect into a customer, many more processes occur after sending a potential customer your invoice.
One of those processes is calculating days sales outstanding (DSO) – a process used by finance managers to track how quickly a customer makes payment after getting the invoice. To keep their cash flow healthy, businesses need to ensure that their customers are paying them within a reasonable amount of time so they can invest the money in other important business operations.
If customers pay on time, it can boost your working capital to buy additional inventory or sort out other business needs. When they fail to pay you within a period you can put the money to good use, your DSO can rise and make you run out of cash – thereby killing your business.
In this article, we will help you understand the concept of DSO, how to calculate days sales outstanding, and other important things to know about maintaining a good DSO for your business.
Table of Contents
- What is Days Sales Outstanding (DSO)?
- DPO vs. DSO: What’s the Difference?
- Days Sales Outstanding Vs. Accounts Receivable Turnover
- Benefits of Days Sales Outstanding (DSO).
- Days Sales Outstanding Formula
- What do a High DSO and Low DSO mean?
- How to Improve DSO?
- Limitations of DSO
What is Days Sales Outstanding (DSO)?
Days Sales Outstanding (DSO) is an accounting metric that measures the average number of days it takes for a business to receive payment for goods and services purchased on credit.
Essentially, it considers how long it takes a business to convert credit sales to cash or to collect its account receivables. The lower the DSO value, the faster the payments are collected while the higher the DSO value, the longer it takes for the company to get its money.
DSO is a key performance indicator popularly used by companies across various industries is used to analyze their accounts receivable and calculate their financial health. Although days sales outstanding (DSO) is generally calculated on monthly basis, some organization calculate their DSO on a yearly or quarterly basis.
DSO is a part of the order-to-cash conversion cycle, which starts when a customer orders an item or service and ends when the payment receipt is issued to the customer. The processes in between the DSO process include order entry, fulfillment, shipping, invoicing, collections, and payment processing.
DPO vs. DSO: What’s the Difference?
Days payable outstanding refers to the average number of days it takes for a business to pay its accounts payable. It measures the days it takes for a company to pay its debts to suppliers, vendors, and financiers.
Unlike DSO, a company with a higher value of DPO generally means that a business is holding onto its cash/ takes longer to pay its bills, which means that the company can retain its available funds to maximize its business benefits.
While this can be a good thing, if a company holds on to the cash for too long, may be a red flag, thereby indicating its inability to pay its bills on time. Calculating your DPO shows how well your company’s cash outflows are being managed.
Days sales outstanding (DSO) on the other hand is the complete opposite of days payable outstanding. It measures how well a company’s cash flow is being managed. A good understanding of how your DSO and DPO financial ratios are can help business managers and investors effectively understand the company’s cash flow.
Days Sales Outstanding Vs. Accounts Receivable Turnover
Days Sales outstanding (DSO) and accounts receivable turnover are two key performance indicators (KPIs) that are important for every business growth.
While DSO is the term that explains the average number of days that it takes for a firm or company to receive payments for their credit sales, the accounts receivable turnover ratio is the average number of times a company receives cash for their accounts receivables over a specific period. Also, check out the detailed guide about gross revenue.
When a business days sales outstanding (DSO) is low, it signifies a good business performance, while a low accounts receivables turnover ratio signifies irregular cash flow – which is bad for any kind of business regardless of the sector or industry.
The formula to calculate account receivables (A/R) turnover ratio is:
A/R Turnover = (Net Credit Sales)/(Average Accounts Receivable)
Benefits of Days Sales Outstanding (DSO).
By constantly tracking your DSO, you can evaluate your business relationship with its customers and the efficiency of its sales team to collect payments from its customers. Calculating your DSO can help you achieve the following:
1. Ensure adequate cash flow
If a company’s days sales outstanding (DSO) increases, it could lead to a financial crisis that can affect the company’s ability to pay its employees or buy inventories. Hence, when a company keeps track of its DSO value and knows when it is rising, it knows the company has a problem collecting receivables, and can effectively resolve the problem. Find the guide about net promotor score.
2. Show that the sales team has been giving credit sales to customers that are not creditworthy
When your sales team report sales growth, but doesn’t tell well about your company’s financial health. This could be a sign that your sales team is not doing well in collecting payments of goods sold on credit. This could also signify that your salespeople are granting longer payment terms to customers that are not creditworthy. From your DSO, you will understand how this is affecting your financial health and find a lasting solution to the problem.
3. Flag customers that fail to pay within the agreed timeline
Consistently tracking your days sales outstanding (DSO) can help you identify your customers that are payment defaulters, thereby enabling you to single those customers out to look into the reason for their delayed payments.
4. Help you motivate your collections department to effectively keep unpaid accounts receivable at appropriate levels.
If your company has a higher days sales outstanding (DSO), it is an indication that your accounts receivable process is poor or underperforming. From this report, you can motivate your payment collection team with various incentives and benefits, to improve their performance and get all outstanding payments within the expected timeframe.
5. Gain insights into other business problems.
A high days sales outstanding (DSO) signifies that your customers are not making payments as promised which can indicate their dissatisfaction with your business or other problems they have with your business. From your DSO report, you can look into these issues by getting in touch with your customers to find out what’s wrong and solve the problem if any to improve your customer experience.
Days Sales Outstanding Formula
Although different organizations across various industries calculate DSO differently, the basic formula for DSO is
DSO = (Accounts Receivable/Net Credit Sales)x Number of days.
To calculate DSO, the first step is to decide how long a time period you want to measure – could be monthly, quarterly, or annually. The example below provides you with better insights on how to calculate your company’s DSO.
If a company X makes a total credit sales of $40,000 and an account receivable of $20,000 in 30 days, the days sales outstanding calculation will be
DSO = $20,000/$40,000)x 30 = 15 days
What do a High DSO and Low DSO mean?
You can understand your business performance much better if you know the difference between a High DSO and Low DSO and how it affects your business. While DSO calculation do not only help you calculate your credit sales but also your cash sales. Aside from those ones, calculating your average DSO can help you measure and track the effectiveness of your accounts receivables.
What is a High DSO?
In simple terms, a high DSO means that a business’s collection department takes more days to collect payment from its customers. A high DSO could be due to two reasons, which are either because the company has customers who are not creditworthy (don’t have the capacity to make payment) or because their cash collection processes are not inefficient. A business that fails to convert its orders to cash which leaves it with a high DSO signifies high bad debt, which could result in poor financial health.
What is a Low DSO?
A low days sales outstanding (DSO) indicates that a company is able to collect all its customer’s outstanding payments. It shows that a company’s cash collection process is efficient with a proactive collection team and has creditworthy customers. A company with a lower DSO value suggests a business’s ability to recover past dues effectively.
A business with a low DSO signifies that it guarantees the inflow of operational liquidity that can be used to achieve other business benefits. A company can have a low DSO for several reasons – could be due to customer satisfaction, an efficient collection team, good customer relationship, etc. Explore the guide related to the compound annual growth rate.
How to Improve Days Sales Outstanding?
Days sales outstanding give you an idea of your company’s financial conditions. If you have a high DSO, there are several ways you can improve your DSO to boost your financial performance. You can optimize your collections in the following ways
1. Sending Timely Payment Reminders
An average business owner goes through a lot to keep the business running and effectively grow the business. For this reason, there is the possibility that your customer could have forgotten to make a payment. By sending them timely payment reminders, you can stay on top of their minds and encourage them to pay as and when due.
2. Offer discounts for early payments
People naturally love freebies, so introducing these in your payment terms can effectively improve your DSO. Giving your customers discounts or coupons for early payments can encourage them to make payments on time. Consider communicating this information with your customers via automated platforms or email campaigns.
3. Identify defaulters and strategize accordingly
Your customers are the lifeline of your business, so if you notice they are not relating properly with you effectively or fail to make payments in the expected timeline, you need to look into the matter to find out the problem and strategize effectively to solve the problem.
4. Accept your customer’s preferred mode of payment
One of the reasons why your customers fail to make payment could be because they are having difficulty completing the transaction from their end. If you ask them and discover the problem with financial payment, you can work on this effectively and accept your customers preferred mode of payment to simplify the process.
5. Invest in an automated system
An automated system can streamline your payment process and enhance your account receivable process. You can automate payment reminders to help you send timely payment reminders automatically while an automated order-to-cash tool can make your account receivables process a lot better.
Aside from this, you can also use an automation tool to improve your collection process, monitor payment status, and customize invoices for every customer.
Limitations of DSO
There are certain situations where days sales outstanding calculation may not be relevant, all of which form the limitations of DSO. These situations include;
- For comparative reasons – comparing a company with many customers who pay on credit with another company with customers who pay in cash.
- When comparing a company that has just had a high increase or decrease in sales with another company with a steady sales record.
- When comparing different companies in different industries with contrasting DSOs
For so many businesses today, calculating the days’ sales outstanding (DSO) number can significantly show a business’s efficiency and a strong indicator of the quality of its cash flow. If a company’s DSO value is too high, it could signal problems for the smooth running of the business operations – with too much cash outside the company.
In as much as customers are the lifeline of a business, if you are leaving too much of your cash with your customers, it could kill your business. It is important to understand that cash delayed is cash lost to your business, hence you must look into ways you can improve your DSO.