We can all agree that understanding cash flow is critical for any business.
Using a simple formula called Days Sales Outstanding (DSO), you can gain powerful insights into your accounts receivable and improve cash flow management.
In this post, we will demystify DSO by explaining what it is, walking through the formula with examples, and showing how to apply DSO analysis to optimize cash conversion.
Introduction to Days Sales Outstanding (DSO)
Days Sales Outstanding (DSO) is an important accounting metric that measures the average number of days it takes a company to collect payment from its customers after a sale has been made. Monitoring DSO allows businesses to evaluate the efficiency of their billing and collection processes.
Defining Days Sales Outstanding (DSO)
The days sales outstanding formula calculates the number of days on average that a company's accounts receivable sit unpaid. It is determined by dividing the accounts receivable balance by the average daily sales. A lower DSO represents a more efficient collection process, while a higher DSO signals potential issues with collections.
The Significance of DSO in Accounting
Tracking days sales outstanding is critical for managing cash flow. The faster a business can collect from customers, the sooner cash is available to fund operations. A high DSO ties up money in receivables rather than freeing it up for other uses. Monitoring DSO over time also provides insight into the financial health of customers.
Exploring the Impact of DSO on the Cash Conversion Cycle
DSO directly impacts a company's cash conversion cycle, which measures how fast cash moves through a business. Minimizing DSO speeds up the cycle by reducing the time between sales and cash collection. This improves liquidity available for paying suppliers and expenses.
The Role of DSO in the Order-to-Cash Cycle
Within the order-to-cash process, DSO measures the efficiency between order fulfillment and payment receipt. A lower DSO means faster customer collections, reducing revenue risk exposure. Tracking DSO identifies potential issues in receivables management so steps can be taken to accelerate collections.
How do you explain days sales outstanding?
Days sales outstanding (DSO) is a key metric used to measure the average number of days it takes a company to collect payment on credit sales. It provides insight into how efficiently a business manages its accounts receivable and cash flow.
The DSO formula is:
DSO = Average Accounts Receivable / (Total Credit Sales / Number of Days)
To explain further:
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Average Accounts Receivable is the average amount of receivables owed to the company over a period of time. This is calculated by adding the beginning and ending accounts receivable balances for the period and dividing by two.
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Total Credit Sales refers to the total revenue generated from credit sales over the analysis period. This is often tracked for a month, quarter, or year.
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Number of Days is the number of days in the analysis period. For a monthly DSO, this would be 30. For an annual DSO, this would be 365.
A lower DSO represents that a company is collecting payment from customers more quickly. This improves cash flow as less money is tied up in receivables.
Benchmark DSO varies by industry, but a DSO between 30-90 days is common for many businesses. If DSO creeps higher, it may indicate issues with collections or credit policies.
Monitoring trends in DSO is important to gauge the efficiency of a company's cash conversion cycle over time. Spikes in DSO should be investigated as it signals customers are taking longer to pay invoices.
How do you calculate DSO with example?
The days sales outstanding (DSO) formula is used to calculate the average number of days it takes a company to collect payment from its customers after a sale has been made. Here is the DSO formula:
DSO = (Average Accounts Receivable / Total Credit Sales) x Number of Days
To calculate DSO with an example:
Let's say a company has:
- Average Accounts Receivable (A/R) Balance = $30,000
- Total Credit Sales for the Period = $200,000
We would plug these numbers into the DSO formula as follows:
DSO = ($30,000 / $200,000) x 365 days
DSO = 0.15 x 365
DSO = 55 days
In this example, it takes the company an average of 55 days to collect payments from customers after making a sale.
The lower the DSO, the faster a company is collecting from customers. A higher DSO means it takes longer to collect payments, which can negatively impact cash flow.
Companies aim to have a low DSO by:
- Having clear payment terms with customers
- Following up on past due invoices
- Offering payment incentives
- Using AR automation to streamline collections
Monitoring DSO regularly helps businesses ensure their accounts receivable process is efficient. Calculating a rolling 12-month DSO helps smooth out monthly fluctuations.
Using the DSO formula to measure days sales outstanding over time is an important accounting KPI for managing cash flow.
How does DSO work?
Days Sales Outstanding (DSO) is a key metric used to measure how efficiently a company collects payment for goods and services. It represents the average number of days it takes for a company to receive payment after a credit sale has been made.
To calculate DSO, you divide the total accounts receivable balance by the average credit sales per day. Here is the DSO formula:
DSO = Accounts Receivable / (Net Credit Sales / Number of Days)
For example, if a company has $100,000 in accounts receivable and averaged $20,000 per day in net credit sales over the past 30 days, the DSO would be:
DSO = $100,000 / ($20,000 / 30 days) = 30 days
This means it takes approximately 30 days on average for this company to collect payment after a sale is made. The lower the DSO number, the more efficiently a company collects from customers.
Monitoring trends in DSO is important to gauge the financial health of a company's accounts receivable. If DSO rises, it may indicate issues with collections or be a sign of increasing bad debts. Taking steps to improve collections processes can help optimize DSO.
What is the formula for true DSO?
The true Days Sales Outstanding (DSO) formula calculates the actual number of days it takes to collect payment on credit sales. This provides a more accurate view of a company's accounts receivable performance than other DSO calculations.
The true DSO formula is:
True DSO = Σ(Invoice Amount x Days to Collect) / Σ Invoice Amounts
Where:
- Invoice Amount = The amount of each individual invoice
- Days to Collect = The number of days from the invoice date to the payment receipt date for that specific invoice
- Σ = Sum of
To break this down:
- The formula first calculates the number of days each individual invoice takes to collect by looking at the invoice amount and days to collect for each one
- It then sums the amount owed x days to collect across all invoices
- And divides this by the total of all invoice amounts
This gives a precise, weighted average number of days to collect across the entire portfolio of credit sales and accounts receivable. It factors in the different amounts and terms for each invoice, rather than averaging all invoices equally.
The true DSO provides a more realistic assessment for managers to evaluate collection performance, anticipate cash gaps, and take action to accelerate receivables. It is more complex to calculate but worth the deeper insight into DSO.
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Calculating Days Sales Outstanding: The DSO Formula
The days sales outstanding (DSO) formula is an important metric used to evaluate how efficiently a business collects payment from its customers. By calculating DSO, companies can gain insight into the average number of days it takes to convert receivables into cash.
The DSO formula provides visibility into accounts receivable, cash flow, and overall business performance. Tracking this metric over time allows financial analysts and business owners to identify trends and opportunities for improvement.
The Days Sales Outstanding Formula Explained
The DSO formula can be broken down into three main components:
DSO = Average Accounts Receivable / (Total Credit Sales / Number of Days)
Where:
- Average Accounts Receivable = Ending AR Balance + Beginning AR Balance / 2
- Total Credit Sales = Net credit sales over the period being measured
- Number of Days = Number of days in the period measured
By dividing average accounts receivable by average daily credit sales, the DSO formula reveals how many days a business must wait on average before collecting payment.
Finding The Inputs for the DSO Calculation
To perform the DSO calculation, financial records and statements must be examined to locate the necessary figures.
The ending accounts receivable balance can be found on the balance sheet. The beginning AR balance requires looking at the prior period's balance sheet.
Total credit sales should be pulled from the income statement, generally found under net sales. Note that cash sales should not be included.
The number of days depends on the measurement period, such as a month, quarter, or year.
Practical Examples of the DSO Formula
Below are two examples applying the DSO formula, walking through from beginning balances to the final DSO calculation.
Example 1
- Beginning AR Balance: $20,000
- Ending AR Balance: $30,000
- Total Credit Sales for Quarter: $150,000
- Number of Days in Quarter: 90
Average AR = ($30,000 + $20,000) / 2 = $25,000 Credit Sales per Day = $150,000 / 90 days = $1,667
DSO = $25,000 / $1,667 = 15 days
Example 2
- Beginning AR Balance: $18,000
- Ending AR Balance: $27,000
- Total Credit Sales for Year: $945,000
- Number of Days in Year: 365
Average AR = ($27,000 + $18,000) / 2 = $22,500 Daily Credit Sales = $945,000 / 365 = $2,590
DSO = $22,500 / $2,590 = 9 days
Understanding the Days Sales in Receivables Formula
Closely related to DSO is the days sales in receivables (DSR) formula. While similar, DSR specifically measures the average time to collect on outstanding invoices rather than all credit sales.
The same inputs are used, except total credit sales is replaced with ending accounts receivable. This subtle change shifts the focus solely to ending balances owed.
Tracking both DSO and DSR provides a more complete picture of collection efficiency over time. Used together, they can pinpoint issues and drive process improvements.
Mastering the Rolling 12 Month DSO Calculation
The days sales outstanding (DSO) metric is an important indicator of a company's financial health and cash flow. It measures the average number of days it takes to collect payment on credit sales.
However, a common mistake is to calculate DSO as a point-in-time snapshot based on the current accounts receivable balance. This approach can produce a misleading view due to one-off events and seasonal fluctuations.
Using a rolling 12 month average helps smooth out these temporary spikes and dips. This provides a more accurate picture of the true underlying DSO trend.
Challenges of Point-in-Time DSO Analysis
Point-in-time DSO calculations can be skewed by various factors:
- Seasonal sales cycles - DSO may spike around peak seasons like holidays or summer
- Large one-off sales - A single big order can inflate AR and overstate DSO
- Payment term changes - Extending terms will push out collections and raise DSO
These events distort the real average time it takes to collect receivables.
Benefits of a Rolling 12 Month DSO Approach
A 12 month rolling average neutralizes these one-off events. By calculating DSO based on the past 12 months of data rather than a single point, it provides:
- Smoothed view of real collection patterns
- Trend analysis rather than seasonal or event-driven fluctuations
- More accurate predictor of future DSO
This gives a reliable metric to set goals and monitor improvement.
Step-by-Step Guide to the 12 Month Rolling DSO
Follow these steps to calculate a 12 month rolling average DSO:
- Determine the 12 month average accounts receivable balance. Sum the past 12 month-end AR balances and divide by 12.
- Calculate 12 month credit sales. Sum the past 12 months of credit sales revenue.
- Divide the 12 month average AR by average monthly credit sales.
- Multiply result by 30 to calculate 12 month rolling DSO.
For example:
12 Month Average AR = $1,500,000
12 Month Credit Sales = $18,000,000
$1,500,000 / ($18,000,000 / 12) = 30 Days
Implementing the Rolling 12 Month DSO Calculation in Excel
Excel makes it easy to automate and update this DSO formula:
- Enter 12 rows of month-end AR balances and 12 rows of monthly credit sales totals.
- Use AVERAGE() formula to calculate 12 month AR and sales averages.
- Input averages into DSO formula and display as days.
- Expand ranges automatically each month to maintain 12 month rolling basis.
Updating monthly will produce a dynamic DSO metric that provides far greater insight than periodic point-in-time snapshots.
Optimizing Cash Flow Using Days Sales Outstanding Insights
Days Sales Outstanding (DSO) is a useful metric for businesses to analyze accounts receivable and optimize cash flow. By establishing a target DSO, revising credit policies, and incorporating projections and analyses, companies can improve working capital management.
Establishing a Target DSO for Cash Flow Optimization
To optimize cash availability, businesses should calculate their current DSO using the days sales outstanding formula and set a realistic target based on their industry. For example, a SaaS company may aim for a 30-45 day target DSO, while a manufacturing firm could set a 60-90 day goal based on longer production cycles. Comparing to industry benchmarks allows businesses to tailor a DSO objective that aligns with their cash flow needs.
Revising Credit Policies in Response to DSO Trends
If a business finds its DSO consistently exceeding its target, credit policies and collections procedures may need to be adjusted. Potential changes could include shortening payment terms for customers, following up more quickly on past-due invoices, or requiring deposits from higher-risk accounts. The accounts receivable turnover ratio can be used to identify if specific customers or products have substantially longer DSO rates. Tightening credit policies helps accelerate cash inflows when DSO starts to creep higher than desired.
Projecting Cash Flow Using DSO and AR Turnover Ratios
The days sales outstanding formula can be used alongside sales projections to model future cash positions. For example, if a firm expects $1 million in sales next month, and its DSO is 45 days, it can estimate $800,000 cash receipts next month ($1 million in credit sales x (1 - (45 days / 30 days per month))). By factoring in the time value of money, businesses can more accurately value cash inflows from accounts receivable.
Incorporating the Time Value of Money in DSO Analysis
Because cash received today is inherently more valuable than future receivables, the rolling 12 month DSO calculation should account for the time value of money. Businesses can adjust DSO figures for the "cost" of waiting by incorporating prevailing interest rates. This allows for more meaningful comparison of DSO numbers over time.
Benchmarking Days Sales Outstanding Across Industries
Benchmarking days sales outstanding (DSO) is an important way for businesses to evaluate the efficiency of their collections process. By comparing your DSO against industry averages, you can determine if your accounts receivable cycle is aligned with sector norms or if there may be opportunities for improvement.
When benchmarking DSO, it's critical to choose appropriate comparisons against businesses in your industry and with similar characteristics. DSO varies widely across sectors due to differences in payment terms, client profiles, seasonality, and other variables.
Comparative Analysis of DSO by Sector
- Manufacturing: 30-40 days
- Software: 45-60 days
- Business Services: 30-90 days
- Healthcare: 30-60 days
These ranges demonstrate the significant variation in typical DSO between industries. Within each sector, company size, target market, payment terms, and other attributes can also impact norms.
Identifying Factors That Influence Industry DSO Norms
Elements that shape a sector's typical DSO include:
- Payment terms: Longer terms lead to higher DSO.
- Client payment behavior: Issues like late payments extend DSO.
- Company size: Larger companies often have higher DSO.
- Seasonality: Industries with seasonal revenue spikes may have a higher DSO.
Choosing the Right DSO Benchmark for Your Business
To make a relevant comparison:
- Select public companies in your niche with comparable size and target customers.
- Understand variances in payment terms offered.
- Consider seasonal impacts on the benchmark company.
Using appropriate benchmarks allows you to gauge performance against meaningful industry standards.
Utilizing Days Sales Outstanding Calculators for Benchmarking
Online DSO calculators can quickly compute sector averages to benchmark against. When using these tools:
- Ensure the source data is reputable and current.
- Select filters to isolate appropriate industry and company size filters.
- Verify if seasonal adjustments were made to the data.
Calculators allow fast access to industry averages, but the comparisons must be relevant.
Understanding the Limitations of Days Sales Outstanding
Days Sales Outstanding (DSO) is an important metric for assessing the health of a company's accounts receivable. However, overreliance on DSO can obscure other vital factors.
The Theoretical Underpinnings of DSO
DSO measures the average number of days it takes to collect payment on credit sales. It is calculated by dividing net credit sales by average accounts receivable.
This theoretical construct makes assumptions. It assumes all customers pay in a similar timeframe and discounts delays from specific customers. While useful for benchmarking, DSO has limitations.
The Potential for DSO Manipulation and Misinterpretation
Techniques like channel stuffing can artificially improve DSO by boosting short-term collections. This presents a misleadingly positive picture of accounts receivable health.
Equally, DSO metrics can be misinterpreted. A low DSO is not necessarily positive if it is achieved by restricting credit to only the most creditworthy customers.
Complementary Metrics to Enhance DSO Insights
Additional metrics should be analyzed alongside DSO:
- Average Collection Period - Measures how long it takes to collect AR rather than credit sales
- AR Turnover Ratio - Assesses how many times AR is converted to cash during a period
- Cash Conversion Cycle - Shows how long capital is tied up in receivables
Together, these illuminate bottlenecks in collecting and converting AR to cash.
The Average Collection Period as a Companion to DSO
The Average Collection Period (ACP) directly measures how long it takes to collect AR rather than credit sales. This complements DSO. If DSO is increasing while ACP is steady, it may indicate a sales spike rather than AR deterioration.
Monitoring ACP alongside DSO provides a more complete picture of AR performance. Unlikely DSO, ACP cannot be manipulated by boosting short-term collections. Comparing the two metrics enhances insights into capital tied up in AR.
Conclusion: Harnessing the Power of Days Sales Outstanding
Recap of Key DSO Concepts and Calculation Methods
- Days Sales Outstanding (DSO) measures the average number of days it takes to collect payment from customers after a sale has been made.
- It is calculated by dividing the accounts receivable balance by total credit sales over a period and multiplying by the number of days in the period.
- Lower DSO indicates faster customer payment and improved cash flow. Higher DSO signals potential issues with collections.
- There are several formulas for calculating DSO including rolling 12 months to smooth out monthly fluctuations.
Strategies for Effective DSO Tracking and Analysis
- Regularly monitor DSO metrics over time to spot trends using accounting software or Excel. Compare to industry benchmarks.
- Break down DSO by customer segment to identify issues with specific customers. Prioritize collections efforts accordingly.
- Set DSO goals and alerts to stay on top of collections and minimize bad debts.
Continuing Education on DSO and Accounts Receivable Management
- Take online courses or read accounting resources to learn techniques like accrual accounting, segmentation, and forecasting to further improve DSO and cash flow.
- Consider professional development and training for staff on best practices in credit, collections, and receivables management.
