Days Sales Outstanding (DSO) is a metric used in financial accounting to measure the number of days, on average, that a company takes to collect its accounts receivable.
Days Sales Outstanding is usually considered along with the metrics of Days Inventory Outstanding (DIO) and Days Payable Outstanding (DPO). Together these three metrics can be used to calculate the cash conversion cycle (CCC).
How is Days Sales Outstanding Calculated?
The formula for calculating days sales outstanding is:
DSO = Accounts receivable x number of days / total credit sales
Where accounts receivable = the cash total of unpaid invoices for a specified period of time. The amount is either an average over the period in question or the final amount at the end of the period. This figure is a proxy for a company’s average unpaid receivables.
Where number of days = the time period specified in the accounts receivable calculation.
Where total credit sales = all the money coming into the company from sales for the period in question. Again this can be an average over the period in question or the final amount at the end of the period. This is a proxy for how fast the company is being paid for sales.
As an example, a company has accounts receivable worth £150,000 for a year period. In that period the total credit sales were £800,000. Thus:
DSO = 150,000 x 365 / 800,000 = 68.4 Days
How to Interpret DSO
As with the calculations for DIO and DPO, it is important to judge the DSO figure in light of how other companies in the same sector fare. The average lag period between a sale and a paid invoice varies from sector to sector.
High DSO
DSO is calculated in days. The higher the number of the days it takes for accounts to be paid up, generally the worse it is for a company. A high number indicates the company is making a lot of sales offering credit. The problem with a high DSO is that it shows that money is being tied up in unpaid invoices. This causes problems for working capital. It is money that has been earnt but is not available for use in buying more materials, paying wages and utility bills, research and development etc.
Low DSO
If the DSO is low – perhaps under 30 days – it indicates good financial health for a company. They are being paid promptly by their customers. This is a great situation to be in: the pot for cash flow is always nicely stocked, and there should be no problems paying for raw materials and other expenses.
How to Improve DSO
If a company is struggling with a high DSO, there are a number of areas that can be looked at to shorten payment times and bring down DSO. They are:
- Making the accounts receivable department more efficient. It is possible to speed up the collection of money owed by analysing the payment behaviour of regular customers and identifying the slow payers. It is then possible to look at ways of encouraging timely payment for these customers.
- Automation. It is now easy to use software that automatically invoices clients digitally. This is faster than generating paper invoices and using the postal service. Further automation can link purchase orders to invoicing, so that as soon as an order is made an invoice is sent. Integrating the company accounting system with the client’s further streamlines the process.
- Using Trade Receivables Finance. This method involves using a third party to pay the invoice. It is called factoring – where a factoring company releases up to 90% of the value of an invoice immediately. The factoring company chases up the debt and when the invoice is paid by the debtor, the factoring company takes its fees and sends the remaining money to the company who raised the invoice. There are a number of factoring options available. Using factoring does cost money but it allows a company to plan its finances and avoid cash flow issues.
- Offer Early Payment Discounts. These incentivise early payment of invoices. A company offers terms whereby a client is given a discount for paying early. Typically, a 2% discount might be offered if an invoice is paid off within 10 days. As they say, money talks. Those clients able to take advantage of early payment discounts will improve their financial health and at the same time the seller will improve their DSO figure.
Cash Conversion Cycle
One of the main uses of Days Sales Outstanding is in the calculation of the cash conversion cycle. This is an essential accounting tool that derives a number for how long, on average, it is taking for money to be spent on materials; those materials to be made into inventory; and then for that inventory to be converted back to sales and cash once an invoice is paid. It is the cycle of turning cash into product and then product back into cash. If the cash conversion cycle is long then money is being tied up that could be used for working capital.
The formula for the cash conversion cycle is:
CCC = DIO + DSO – DPO
Where DIO = Days Inventory Outstanding
Where DSO = Days Sales Outstanding
Where DPO = Days Payable Outstanding
Use the links on the terms to delve deeper into each metric.
In Summary
The Days Sales Outstanding is a key metric used in company accounting to assess how promptly payments for goods sold are taking. It can be measured over time to monitor whether clients are taking more or less time to pay than usual.
As discussed, there are a number of actions available to a company that wishes to reduce its DSO and thus improve cash flow. These measures range from automating invoices, to using third party factoring firms.
Finally, DSO is an important metric that can be used to calculate the cash conversion cycle when used in tandem with DIO and DPO.
