Days Sales Outstanding (DSO) is a widely used method to help evaluate how effective a company is at collecting receivables. This metric is used to measure the average number of days it takes a company to collect what is owed to them after a sale has been completed. Put in fewer words, it is the average collection period. There is much to know about measuring and interpreting DSO, and we have a few words of caution as well when analyzing DSO.
HOW TO CALCULATE DSO
DSO = Accounts receivable/total credit sales x number of days in period.
WHY IS DSO IMPORTANT?
Your ability to quickly collect outstanding accounts receivable has a direct impact on cash flow. Since cash plays a fundamental role in operations and growth, it is important to know how effective and efficient your company is in collecting that money so it can be reinvested back into the business.
HOW TO INTERPRET DSO
Each industry has different standard payment terms so it is not possible to say that every company should have a DSO of “X”. Do some research on average DSO in your industry and see where you measure up.
- A low DSO is an indicator that a company is collecting receivables quickly; generally this is a positive sign.
- A high DSO proves that a company takes longer to collect on credit sales and can indicate current or impending cash flow problems, operational issues, or a lack of effort or focus on credit collections. A few of the ways to battle high DSO is by implementing accounts receivable management software, a proven tool for reducing DSO, changing your credit terms, or running more in depth credit checks before extending credit to customers.
Typically you want DSO to exceed your terms by no more than half. So if you operate on payment terms of 30 days and you’re seeing payment in 45 days, you’re doing pretty well. There are other ways to set goals and benchmark though, including using a best possible DSO calculation.
DSO V. BEST POSSIBLE DSO
Best possible DSO differs because it only takes into account your company’s current receivables, not the invoices that have yet to come past due. The goal is to get your DSO as close to the best possible DSO calculation as you can, indicating you are collecting on invoices as quickly as possible. It is nearly impossible to get these numbers to match up perfectly, so if you can get within 3-5 days you are doing great!
Best Possible DSO= (Current receivables x number of days in period) / credit sales for period
KEEP IN MIND THE FOLLOWING:
DSO is an important measurement for benchmarking and goal setting, but it should never be used as an end-all-be-all indicator of your accounts receivable performance. Other accounts receivable metrics such as average days delinquent and collection effectiveness index should also be used to paint a complete picture of your collection success. Other things to be mindful of when looking at DSO include:
- DSO fluctuates with revenue and other short-term changes. For example, if your sales increase and your past due receivables stay the same in a month, your DSO will go down- but in this situation that does not mean your collection efforts have become more efficient. For this reason DSO should not be used as the only indicator of success or failure.
- DSO can be affected due to short-term fluctuations in sales or collections, best practices dictate that companies should compare DSO to past periods quarterly or annually to allow enough time between measurement dates for an accurate reflection and interpretation.
- Because of its tendency to fluctuate, analyzing DSO on a period less than a year can be misleading.
- DSO takes into account only credit sales, not cash sales.
- Always look at your DSO with context with your company’s terms.