Published on 17 October 2023
Updated on 22 July 2024
Days Sales Outstanding (DSO) is a poorly known yet key indicator in managing and improving your cash flow. If you want to know more about what DSO is, how to calculate it and work on DSO improvement, the following is a close-up on these three letters that will help you implement an efficient and balanced credit risk policy.
Summary
The Days Sales Outstanding, for a given company, is the average time of payment for its commercial invoices. In other words, DSO is the average number of days it takes you to collect payment for a sale.
For example, if your DSO is equal to 32, it means it takes you 32 days on average to collect payment from your customers after sales.
If you frequently use trade credit, it is a central indicator for assessing your ability to receive payments on time. Given the vital importance of cash flow to run your business, it is of course in your best interest to collect your outstanding account receivables as early as possible. By quickly transforming sales into cash, you can use or invest this cash more quickly.
You can calculate DSO every month, every quarter or on an annual basis, for your whole customer database, but also for a specific customer. It can for example help you identify the customers that take the longest time to pay you.
Wondering how to calculate DSO? The DSO formula works as follows, for a given period:
DSO = (accounts receivables / total sales) * number of days
For example, over the month of January, ABC Ltd has sold for €50,000 worth of goods, with €35,000 in accounts receivable on its balance sheet at the end of the month.
What is its DSO? The DSO calculation is: (35,000 / 50,000) * 31 = 22.3 days. It means that on average in January it took ABC Ltd 22 days to collect payment after a sale had been made.
The DSO formula takes only credit sales into account. Cash sales are not included in the DSO calculation and could be considered like having a DSO equalled to 0.
The DPO (Days Payable Outstanding) is your mirror indicator: it allows you to see how many days you take on average to pay your invoices.
DPO = (accounts payables / cost of goods sold) * number of days
For example, over the year 2019, Star Fresh has spent £280,000 worth of COGS, with £30,000 in accounts payables on its balance sheet at the end of the year. Its DSO is: (30,000 / 280,000) * 365 = 39.1 days. It means that on average in 2019 it took Star Fresh Ltd 39 days to pay its bills and invoices to its creditors (suppliers, vendors, etc.)
So when considering DSO vs DPO, remember that DSO is the average number of days it takes your customers to pay you, while the DPO is the average number it takes you to pay your suppliers.
The DSO allows you to assess your ability to convert your trade receivables into cash. These, along with inventories, make up the main element of your working capital.
The higher your DSO, the greater your working capital, and the lesser your free cash flow.
To that effect, the DSO is a key indicator of the financial health of your company.
Now that you know how to calculate DSO, you need to know how to interpret it.
DSO improvement only makes sense in relation to your business strategy. In theory, a company or a sector that is accustomed to selling on credit will have a higher DSO.
As with working capital, the variation of the DSO from one period to another is what counts, more so than its absolute value.
Example 1: Company A is used to selling on credit on its domestic market – usually around 10 days – but is now expanding to a foreign country, with a large customer that turns out to take longer to pay the invoices – about a month. Company A’s average DSO is going to go up from 10 to 15 days.
Example 2: Company B has a loyal and regular customer base and usually allows a payment term of one month. For several months, its DSO has stabilised at roughly 30 days.
In this case, it is company A that must be particularly careful, despite a lower DSO: its ability to be paid on time, and therefore its free cash flow, has deteriorated. Company B however is aware of its average DSO and has anticipated it.
Financially speaking, it is always good to lower your DSO. However, it can be beneficial commercially to offer your clients an attractive trade credit policy, which will mechanically raise your DSO. To get tips on finding the sweet spot between protecting your financial situation and offering attractive terms, have a look at our article on how to negotiate payment terms.
How to Reduce your Days Sales Outstanding
Reducing DSO is not completely within the control of your company's finance and accounting departments. Other parts of the company also have an impact on this metric. Therefore, reducing DSO requires not only a focused effort on the part of finance executives, but the cooperation of various departments in the company as well. Below, we outline six simple steps to begin reducing your company’s days of sales outstanding in accounts receivable.
1. Gather data about current DSO status
Any effort to reduce DSO must begin with gathering data on a company’s current DSO status and creating a benchmarking analysis that shows how that level of DSO compares to peers and competitors. This insight not only provides a starting point for the effort, but also provides a sense of what DSO ratio is attainable for the business. To compare your business's status to others, the Hackett survey offers some basic data by industry. For greater detailed data, consider other industry surveys or private benchmarking studies.
Accounting and finance executives can also use this data to make the case for reducing DSO to senior management and the various departments whose cooperation is necessary. By making DSO reductions a strategic priority, executives can more readily justify the resources they devote to the project and incorporate DSO improvement metrics into the individual performance objectives and incentives of those driving the effort.
2. Focus on customer credit
DSO is often driven by your customers' ability to pay their invoices on time. Therefore, any effort to improve DSO must address customer credit risk. A good first step is to determine appropriate parameters for acceptable customer credit risks. A company can then use that criteria to ensure that all new customers do not represent an unacceptable risk of slow payment or non-payment. Companies can also extend these criteria to existing customers, starting with those that have been slow to pay.
The sales function of a business must be on board with this renewed focus on customer credit risk. Salespeople do not want to lose a sale because a customer has credit problems. Therefore, companies may need to implement specific incentives and penalties to make sure salespeople and sales managers adhere to the company’s customer credit requirements
3. Define customer payment terms
DSO metrics are heavily influenced by the payment terms a company extends to its customers. Those payment terms must carefully balance the company’s own DSO goals against common industry practice, as well as customer needs and expectations. This means identifying under what circumstances the company will offer customer incentives for faster payment or require deposits or upfront payments, supported by a clear approval process when making these decisions.
Invoices must clearly and visibly state payment terms to reduce the chances of confusion over when payment is expected. The company should also be regularly communicating with customers about outstanding invoices and how the company can make it easier for customers to pay them. For example, some customers may be moving to electronic payments or prefer their employees use payment cards for certain purchasing.
4. Look at invoicing processes
Slow or inefficient accounting processes can also extend DSO. Therefore, improving DSO often requires a focus on making sure that invoices are going out on time, contain all necessary information and are free of errors. A thorough review of the billing process, including spot checking invoices, can uncover errors, that could delay payment. Incorrect charges, invoices that do not reflect agreed-upon discounts, or the wrong mailing address are just a few examples of common errors that can delay payments.
Companies should also regularly review and update policies on when to send invoices and make sure that those policies are being followed. Consider sending invoices when the contract is signed, at delivery, or using some other milestone. Companies should also be auditing invoice processes to identify delays or errors.
5. Manage accounts receivables carefully
Once invoices have been sent, a company must have a plan for following up on outstanding balances and reminding customers of unpaid invoices. This communication should focus on identifying any problems that are preventing the customer from paying the invoice. In some cases, an otherwise strong customer may be having cash flow problems and may be appropriate to offer a special arrangement or payment plan.
If non-payment continues, the company should have a clear policy and process for handling these situations and any disputes that arise, including guidelines on when and how to escalate the situation as needed.
6. Keep up the momentum
Companies must commit to reducing DSO and sustaining this effort over the long term. Reducing DSO often requires changes to habits as much as administrative processes and procedures. Therefore, companies will need to make sure those changes stick and people do not return to the old ways of doing things. By conducting regular reviews and discussions about DSO metrics, companies can keep the focus on these efforts and reinforce their importance to the company.
Trade credit insurance remains one of the most efficient solutions to ensure the stability of your DSO. With trade credit insurance, you are insured in the event that a credit cannot be recovered. As a result, you are guaranteed that a potential bad debt will not have a negative impact on your working capital.
In conclusion, more than lowering your DSO, it is important that you keep it under control: a rising DSO is a sign that you are no longer in control of your invoicing and debt collection process and that your financial health is deteriorating. It is therefore important to constantly monitor it and work on improving it while maintaining good relations with customers.
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