If your business sells on credit, getting paid swiftly is a make-or-break factor. Maintaining a low days sales outstanding (DSO) is critical to keeping your business cash flow healthy. Learn more about this important metric.
What is Days Sales Outstanding (DSO)
Days sales outstanding (DSO) is an accounting metric that indicates how long your firm takes to collect payments once sales are made. The lower the DSO, the less time it takes for your firm to convert accounts receivable (A/R) to cash.
DSO is a component of the order-to-cash cycle (O2C), meaning the entire sales process from receiving a customer order to receiving payment in full. DSO is also a component of the cash conversion cycle (CCC), which represents the amount of time that liquid assets are tied up in working capital.
Why is DSO Important?
A climbing days sales outstanding number can mean your company is struggling to collect on its invoices and may be headed for cash flow trouble. And while a lower DSO is almost always better, an unusually small number compared to industry norms could suggest that your company’s credit policies are too stringent and that you may be missing out on growth opportunities.
Benefits of DSO
Tracking your company’s days sales outstanding can enable you to:
● Identify dissatisfied clients or those experiencing financial distress
● Determine whether your credit policies are too lenient or too restrictive
● Offer the right payment options and incentives for early payment
● Measure the efficiency of your internal bookkeeping procedures
● Incentivize your A/R department to follow up on unpaid invoices
● Ensure that your business has adequate cash flow to meet its obligations
● Improve cash flow forecasting and long-range strategic planning
● Gain insight into broader industry trends or macroeconomic conditions
Limitations of DSO
While days sales outstanding has definite value as a key performance indicator (KPI), caution is advised when:
● Comparing firms with different business models or in different industries: For example, specialty retailers tend to get paid much faster than engineering firms, but that doesn’t necessarily make one line of business more stable or lucrative than the other. You’ll want to compare your DSO number to those of comparable enterprises.
● Evaluating a business with significant seasonal or cyclical volatility in sales: When sales activity spikes, DSO often spikes too, and this isn’t necessarily a meaningful indication of your company’s overall financial health. Likewise, a DSO that suddenly drops might be due to sluggish sales, in which case it wouldn’t be welcome news.
● Viewing the metric outside the context of a complete data dashboard: DSO is just one of many metrics your business should pay attention to. DSO can provide valuable insight into your client relations, accounting practices and cash position. But it’s best interpreted alongside other cash flow KPIs like liquidity ratios and the average number of days it takes you to pay your suppliers (days payable outstanding or DPO).
How to Calculate DSO
Over a given period, DSO measures the average number of days between the delivery of products or services and the receipt of cash payments. Periods may be monthly, quarterly, yearly or any other time frame that makes sense for your business and can be directly compared with relevant benchmarks.
To calculate DSO, you’ll need to refer to your company’s balance sheet and income statement for that period, which will show A/R balances and revenues. (This assumes that your business uses the accrual method of accounting, not the cash method.)
DSO Formula
Here’s how to crunch the numbers:
Days Sales Outstanding = (Average A/R ÷ Net Credit Sales) × Number Days
● To calculate Average A/R, add the beginning and ending A/R balances for the period you’ve chosen to analyze and divide by 2.
● To calculate Net Credit Sales, take your gross revenue for the period and subtract any cash sales, incidental revenue, product returns or discounts.
● Number of Days means the number of calendar days in your measured period.
DSO Calculation Example
Let’s say you want to find your company’s days sales outstanding for Q3 2023. During that period, you recorded $700,000 in net revenue. On July 1, your A/R balance was $400,000, and on September 30, your A/R balance was $200,000, giving you an Average A/R of $300,000. There were 92 calendar days in Q3. Plugging these values into the formula looks like this:
Days Sales Outstanding = (Average A/R ÷ Net Credit Sales) × Number Days
(300,000 ÷ 700,000) × 92
You get a DSO of 39.43. In other words, during Q3 2023, your company took about 39 days on average to collect payments.
Applications of DSO
As a single data point, days sales outstanding can be used to get a quick read on your company’s cash position. It can provide you at-a-glance data that helps you understand sales numbers and if your customers are paying you on time.
However, it’s particularly meaningful to track DSO over time, so you can analyze emerging trends and spot potential problems before they derail your operations. Those trends can help you understand if your credit and sales teams are working together to establish effective payment terms and if the invoicing process is working efficiently. That’s why many finance experts recommend that businesses use DSO as part of their regular benchmarking and forecasting toolkit.
What is Considered a Good or Bad DSO?
While there aren’t many one-size-fits-all rules in business or in life, a DSO under 45 is generally considered good. Another helpful guideline is that your DSO shouldn’t average more than 125% of your net payment terms. For instance, if you operate on net-30 terms, your DSO should stay under 37.5.
Again, trends are more important than individual numbers. If your DSO has surged from 20 to 40 year-over-year without a corresponding increase in sales, that could spell peril, even if 40 isn’t necessarily a “bad” number. Conversely, seeing your DSO tick down from 52 to 50 to 48 in successive quarters could signal that your client relationships and internal operations are running smoothly.
To optimize your DSO, check out these actionable tips from Allianz Trade Canada.
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