Days sales outstanding (DSO) is a working capital ratio which measures the number of days that a company takes, on average, to collect its accounts receivable. The shorter the DSO, the faster the company collects payment from its customers – and the sooner it is able to make use of its cash.
Consequently, the CCC can be optimized – in other words, reduced – by increasing DPO or reducing DSO or DIO.
DSO is expressed in days and is usually calculated as follows:
DSO = accounts receivable x number of days/total credit sales
Accounts receivable is the total value of accounts receivable during a particular period. Some companies will use the average accounts receivable balance during the period, while others may use the closing accounts receivable balance.
Number of days is the number of days in the relevant period – which may be a month, a quarter or a year.
Total credit sales includes sales which are made on credit – in other words, are due to be paid on a future date – as opposed to cash sales, which are paid immediately.
For example, if a company has credit sales of $1.2 million over the year, and an accounts receivable balance of $120,000, DSO would be calculated as follows:
120,000 x 365/1,200,000
= 36.5 days
What does DSO mean?
Typical DSO metrics will vary considerably between industries. However, by comparing a company’s DSO with other companies in the same sector, it may be possible to draw some conclusions about the company’s cash flow and working capital performance.
High DSO vs low DSO
If a company has a high DSO, that indicates that the company is selling products on credit and is taking a long time to collect payment from its customers. This can result in cash flow difficulties, as raw materials may need to be purchased in order to produce the goods being sold.
A low DSO means that the company is collecting payment from its customers rapidly and is therefore able to make better use of its working capital.
For companies with a high DSO, there are some actions that can be taken to reduce DSO and thereby improve working capital performance:
Speeding up the collections process. For one thing, it may be possible to improve the performance of the company’s accounts receivable department by improving the efficiency of the collections process. This may involve segmenting customers in accordance with their payments behavior and focusing the most proactive collections efforts on the customers that are most likely to go significantly past due.
Automating the invoicing process. Another effective strategy is to automate the invoicing process through the use of electronic invoicing solutions. An electronic invoice will reach its destination faster than a traditional paper invoice – and it may be possible to integrate the invoicing process with your customer’s system, further streamlining the invoice submission process and reducing the likelihood of delayed payments. Electronic invoicing solutions include systems which automatically convert a purchase order (PO) into an invoice, as well as the use of system-to-system integration in order to send large volumes of invoices quickly and efficiently.
Accessing receivables finance. Companies may also improve DSO by taking advantage of receivables financing solutions which enable companies to receive payment from their customers earlier. These include financing techniques such as factoring, invoice discounting and asset-based lending, which are initiated by the company seeking early payment on its invoices.
Offering early payment discounts. Companies sometimes improve DSO by offering their customers early payment discounts. The traditional approach is to offer customers closely defined discounts such as ‘2/10 net 30 days’, meaning that the buyer receives a 2% discount if they pay the invoice within 10 days instead of within 30 days.
Supply chain finance enables suppliers to receive early payment on their invoices from a third-party funder. The cost of funding is based on the customer’s credit rating rather than the suppliers, typically resulting in a lower cost of funding.
Dynamic discounting enables suppliers to offer their customers early payment discounts in a more flexible way. Using this model, customers can offer early payment at any time between approving an invoice and the invoice’s due date, with a higher discount available the sooner payment is received.
By facilitating early payment, both types of solution can enable suppliers to reduce their DSO.