Sep 18, 2020
Do you have a set of key performance metrics/indicators (KPIs) used to analyze your business's performance? If not, KPIs are something you should strongly consider. Performance metrics provide insight into the health of a business. One important performance metric, which tracks payment on credit, is DSO.
DSO measures the performance of a company's credit payment policy over time. The DSO value by itself isn't useful. Only when plotting across time do you gain insight into how well your credit payment process works. In this article, we'll go through what DSO is and how to calculate it.
What is days sales outstanding?
Days sales outstanding is a performance metric that measures the average number of days it takes customers to pay invoices. Or you can also say the average number of days to collect on invoices outstanding. Basically, DSO answers the question, how long does it take for customers to pay you?
In most industries, customers receive some grace period. It might be 10, 15, 30, 60, or 90 days (i.e., net terms). Customers will pay around the due date with some paying sooner, some later, and some on the date. This creates an average called DSO.
What is the days sales outstanding formula?
The days sales outstanding formula is calculated by:
*[Accounts receivable balance (average)] / [annual credit revenue] x 360
As the accounts receivable (AR) average increases but sales remain the same, DSO will also increase and vice versa. But that ratio may not be too useful since AR and sales are often fluctuating.
Days sales outstanding example
As an example:
Accounts receive average = $5 million
Annual credit sales = $20 million
5 / 20 x 360 = 90 days
This means customers are taking 90 days on average to pay their invoices. If the company allows only 60 days for customers to pay their invoices, this is obviously an issue, since 30 days of free credit is being extended.
Why businesses need to track days sales outstanding
Tracking performance metrics can help you keep a pulse on your business. But it's important to know which are faster moving and what their impact on the business might be. DSO isn’t a fast-moving metric since its trend is only realized over time. But it isn’t exactly slow either as a trend can be seen in only a few weeks to a month. Below are a few reasons why it's important to keep an eye on your DSO trend.
Avoid cash flow issues
There is a direct relationship between DSO and cash flow. As DSO goes down, the company takes in more cash through customer payments since customers are decreasing their average time to pay.
When DSO increases, customers hold onto their payments longer. This can create a cash flow crunch where money going out (to pay vendors/suppliers) is not being replenished fast enough by money coming in.
Generate more revenue
By tracking and minimizing DSO, thus increasing cash on hand, you can generate more revenue in the future, according to the time value of money.
Improve customer satisfaction
Tracking DSO helps shed insight into how happy customers are with your product. This assumes customers pay sooner because of overall satisfaction with the company or product.
DSO may also decrease because of discounts customers receive for paying earlier — another form of customer satisfaction. For example, a 2/10 net 30 invoice means the customer will receive a 2% discount if they pay within 10 days. Else, they have 30 days to pay. If your discounting methods are effective, customers are expressing satisfaction with the discounts offered by taking advantage of them. These quicker payments can have an overall positive impact on DSO (by decreasing it).
How to interpret DSO
The direction that DSO is moving says a lot about your collections process and the effect any improvements in DSO are having. A flat DSO is also telling as it shows a stable customer base but could also mean that any improvement efforts are not working.
What does a low DSO mean?
Small businesses typically have a lower DSO
Small businesses depend on shorter payment windows to maintain cash flow. Small businesses generally do not have large cash reserves so incoming cash is critical to maintaining operations.
Faster collection process
A low DSO means customers are settling accounts quickly. This can be a good sign but it can also mean your payment process is too aggressive. If that is the case, loosening up your credit payments (i.e., allowing for more grace period) may attract new customers.
Do cash purchases decrease DSO?
You might be tempted to assume that cash purchases decrease DSO. However, that is not the case. Recall from the above formula that the DSO calculation uses credit sales, not total sales, which include cash.
What does a high DSO mean?
Bigger businesses can afford a higher DSO
Bigger businesses often have more cash flow and greater leeway for payment windows. Additionally, it is likely common in their industry to offer certain credit terms, such as net 30 or 60.
More purchases made on credit
A higher DSO may mean that more customers are using credit to purchase. However, if DSO is trending higher and, in particular, above a company’s net days (i.e., net 45), corrective action should be taken. In this scenario, customers are increasingly paying late on their invoices.
Longer payment terms
A higher DSO may mean that salespeople are offering longer repayment terms to customers. Customers generally favor better credit terms. If salespeople are able to make more sales, increasing their commissions in the process, they may provide more generous credit terms.
Conclusion
DSO is a performance metric that should be viewed as a trend. This means consistently tracking your DSO over time and plotting it. After plotting your DSO, interpret why it has a particular trend. With the knowledge you’ve gained in this article, you should be able to determine now why your DSO is trending in a certain direction.
Recognizing when DSO is changing its trend allows you to take action, such as implementing corrective measures. If you’ve been making improvements by analyzing the DSO trend, you’ll now have evidence of whether those improvements are working or not.
