Days Sales Outstanding or DSO is a key working capital metric.
We will cover the definition of Days Sales Outstanding, go through an example of how
to calculate the DSO ratio, discuss the importance of DSO,
and show 5 ways to analyze and improve DSO.
Days Sales Outstanding, which is sometimes called Average Collection Period, is the average
number of days that customers take to pay invoices.
From a cash flow perspective, we would like DSO to be as low as possible.
It is important to understand that if DSO goes up, then cash flow goes down.
The reverse is also true: if DSO goes down, then cash flow goes up.
How to calculate the DSO ratio?
Days Sales Outstanding equals the average accounts receivable balance in the numerator,
divided by 12 months revenue in the denominator,
and the outcome of this is multiplied by 360 days.
You find the average accounts receivable balance on the assets side of the balance sheet, and
the revenue in the income statement.
Let’s take an example of how to calculate DSO.
If the average accounts receivable balance is $10 million, and the revenue for the year
is $50 million, then Days Sales Outstanding is 360 divided by 5 is 72 days.
It’s advisable to take the average quarter end balance of accounts receivable, which
you can find in a company’s annual report and its quarterly earnings releases.
For example, Q4 last year’s balance was $10 million,
Q1 8, Q2 11, Q3 9, and Q4 $12 million.
This company, like many others, has seasonality in its sales, and therefore seasonality in
its receivables balance.
If you had only taken the Q4 ending balance of $12 million into the calculation, the DSO
would have been 86 days.
If you had taken the average of Q4 last year and Q4 this year, which is $11 million, the
DSO would have been 79 days.
The 5-point average is most representative, and the data can be found in the publicly
filed reports of the company.
If you work for a company as an employee or an auditor and have access to internal management
reporting, you could even do a 13-points average by taking the average of last year’s ending
balance and the 12 monthly ending balances of the year.
In the denominator is a full year’s worth of revenue.
Why would we multiply by 360 days and not 365?
Well, finance people sometimes simplify calculations like DSO by assuming a year has 12 months
of 30 days each.
It makes for nice round numbers in this example!
Why is DSO so important?
Because payments from customers are a key driver in Cash From Operating Activities!
The incoming cash from customers paying on time and in full is as important for a company
as it is for human beings to have oxygen to breathe.
If you get cash in from customers, you can pay the invoices sent by your suppliers, the
salaries of your employees, the taxes you owe to the government,
and the interest you owe to the bank.
If you don’t get cash in from your customers, then you might temporarily stay in business
by borrowing more money or selling assets to pay your bills.
If there is a structural problem with getting paid by customers, a company is likely to
end up going bankrupt.
DSO is the key metric to measure the ability to collect.
Analyzing and improving Days Sales Outstanding.
Once you have calculated DSO, how do you interpret DSO?
A common place to start, for those that have access to internal management reporting data,
is to figure out the split between terms and past due.
The data might show that across the company, the average terms agreed in contracts with
customers are 45 days.
Versus those credit terms of 45 days, customers pay on average 27 days late!
It is important to dig one level deeper in this: maybe the majority of the customers
pay per the credit terms or only slightly behind, but some outliers have past dues of
60 days, 90 days or more.
If customers are that late in paying, there is a chance that they will never pay, and
you may have to put in a provision for doubtful debts.
What is the root cause of customers paying late?
Are they unwilling to pay, due to quality, shipment or invoicing issues?
What needs to be done to remediate that?
Are they unable to pay, which makes you wonder whether the customer due diligence and credit
review processes in the company are sufficient.
A second analysis you could perform is to analyze which part of the revenue of the company
is generated with immediate cash payment from customers versus on credit.
Perhaps $10 million out of the total $50 million is paid cash on delivery (DSO of 0 days),
and $40 million is on credit (with 90 days DSO).
The weighted average is 72 days, and it makes you wonder why the company is so generous
in providing 90 day free loans to its customers that do get credit.
The third avenue of DSO analysis is to look at monthly seasonality.
If 50% of quarterly revenue is in month 1 and 2, and 50% in month 3, then there are
bound to be a lot of invoices outstanding in the accounts receivable balance at the
end of the quarter!
For example, if half of the Q4 revenue is shipped and billed in December, then even
with 30 day terms with customers the payment for those December invoices will only come
in in January, and the December 31st accounts receivable balance will be high.
Focusing on stable operations, selling and shipping similar amounts in every week of
the quarter, could reduce the cost of overtime and expediting, and reduce DSO!
It is also very useful to look at how Days Sales Outstanding has developed over time.
If DSO was 65 days two years ago, 68 days last year, and 72 days this year, then either
the company has become more generous in granting longer credit terms to its customers, or the
amount of past dues has increased.
My fifth suggestion for DSO analysis and improvement: geographical analysis!
The fictitious company we are analyzing in this example might be operating globally,
with six key geographical markets: Sweden, USA and Germany with DSO in those countries
below the company average, and Spain, Italy and the United Arab Emirates with DSO above
the company average of 72.
The more global a company gets, the higher the DSO might get as a result.
I hope you enjoyed this explanation of Days Sales Outstanding.
We focused on the definition of DSO, how to calculate DSO, the key importance of DSO,
and 5 ways to analyze and improve DSO.
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