days sales outstanding (DSO)

Formula for DSO

It is important to first note that the DSO calculation only considers credit sales; it does not account for cash transactions.

The days sales outstanding formula can be written as:

(accounts receivable / sales revenue) X number of days in measured period = DSO

An effective way for businesses to use the DSO calculation is to keep it tracked month by month on a trend line -- or a series of plotted data points indicating a certain pattern or direction. Using the DSO in this way can help companies see any changes in their business's ability to collect payments from customers. A seasonal business can use a variation of this analysis by tracking the same month's metric on a year-by-year rate.

Every business is different and, consequently, there is no set DSO amount that indicates good or bad accounts receivable management. Therefore, when using days sales outstanding to compare various companies, analysts should make sure they are comparing businesses that are as similar as possible; ideally, they should be within the same industry and operate with similar business models and revenue numbers.

Example

Consider this hypothetical example: A company wants to calculate their DSO for the month of May. Their sales revenue is $700,000 and they had $400,000 in accounts receivable. There are 31 days in the month of May. Therefore:

($400,000 / $700,000) X 31 = 17.71

Using this formula, the company will find that, on average, it takes them a little under 18 days to collect payments after a sale has been made.

Applications of DSO

The value of days sales outstanding can be applied in a variety of ways. For example, it can indicate how many sales have been made during a specific time frame; whether or not the company's collections department is operating efficiently; the speed at which customers are paying; whether or not customer satisfaction is being maintained; or if credit is being given to unworthy customers.

In general, a high DSO number is usually a bad indication, while a low DSO number is a good indication.

A low DSO number generally means that it takes the company less time to collect payments. Although it varies depending on the business type and structure, DSO numbers under 45 days are considered low. A low DSO value may also indicate that customers are paying on time or even early to benefit from discounts or the company has a very strict credit policy in place.

Having a low DSO value is especially beneficial for small to medium-sized businesses (SMB). Fast credit collection means the money can be sooner used for other operations. Furthermore, any excess money collected can be immediately reinvested in order to increase future earnings. As a result, as a company's DSO value decreases, its liquidity and cash flow increase.

A high DSO number reveals that a company is taking longer than it should to collect accounts receivable from customers. The impact this can have on cash flow significantly affects smaller businesses who rely on the fast collection of payments to provide for operational expenses, like utilities and salaries.

To lower the DSO, a company must first determine what factors are affecting the sales and collection rates. Potential causes could be:

• A company's sales team is offering longer payment terms in the hopes that it will increase sales.
• Similarly, the company is encouraging customers to purchase with credit with the hope that this will generate the sale of more products and services.
• The company's collection department lacks efficiency and control.
• The customer has a preexisting negative credit standing.

While evaluating a specific DSO value can provide quick information about a company's cash flow, examining trends in the DSO over time can be more beneficial and impactful to a business's processes. A company may use an increasing DSO as an indication of a decline in customer satisfaction; longer terms of payment are being offered to boost sales; or customers with poor credit scores and history are being allowed to purchase on credit. Furthermore, increasing DSO will continue to impact a company's cash flow over time -- especially if the company relies on a consistent payment -- and may force the business to make large, costly changes.

Limitations of DSO

DSO should always be analyzed within the context of the company's terms and structure. Limitations of DSO calculations and the information they provide include:

• DSO does not consider cash sales, only credit transactions.
• DSO cannot compare companies with significant differences in the ratio of sales that are credit versus cash, since the calculation does not consider cash payments.
• DSO changes along with revenue and other short-term fluctuations. Therefore, DSO should not be used as a perfect indicator of a company's accounts receivable efficiency since a decrease in the DSO value may not actually indicate improved efforts by the company's collection department. It could simply be that sales increased while past due payments remained the same, thus creating a lower DSO number. Furthermore, analyzing DSO on a period less than a year can present misleading results.
• It is hard to apply the traditional DSO method to businesses that experience seasonal trends. Some financial analysts attempt to mitigate this problem by using an average receivable number for the business as well as a daily average of sales based on 30 to 90 days instead of the whole year.

Since the information provided by DSO is limited, analysts should be sure to use various other calculations when examining a company's cash conversion cycle.

Importance of DSO

As mentioned before, DSO is an important tool for measuring the liquidity of a company's assets, or the amount of cash the company has on hand as well as the amount of assets that can be readily converted into cash. Since cash is extremely important for business operations, the quick collection of accounts receivable is in the best interest of the company. Furthermore, DSO can also be used to examine the company's overall efficiency and profitability. Low accounts receivable collection times means a company can more efficiently reinvest their cash in order to generate more sales.

It is also important to measure the DSO because it can be used to gauge the effectiveness of the company's accounting department as well as identify any threatening problems or vulnerabilities so they can be resolved before they happen. The DSO can also be used to build financial models that can be used to improve or solve these threats or problems.

Managers, investors and stakeholders rely on DSO to determine how effective a company is at collecting outstanding balances from customers. Business acquirers use the calculation to find companies with high DSO values, with the intention of procuring the business and improving their collection and credit processes. Finally, DSO is a crucial calculation to analysts who are looking to compare companies to see how well they manage credit and use receivables to grow their business.