Poor cash management is one of the leading causes of revenue leakages. In fact, if this issue is not addressed, the losses could accrue to a point where it leads to bankruptcy! However, as an artist or a creative professional, monitoring or improving cash flow might seem like a challenging task. After all, managing finances or crunching numbers may not be your forte at all!
Fortunately, keeping a tab on a few financial metrics, such as the Days Sales Outstanding ratio, can help you stay afloat.
This post discusses everything you need to know about Days Sales Outstanding, its formula, and calculation. Let’s get started.
Every sale generates revenue. But except for certain industries, like retail or hospitality, which accept immediate transactions, the trade or sale often takes place with the raising of invoices. These invoices contain a detailed list of the goods and services, their per-unit cost, total quantity, and the final charge.
However, merely forwarding the invoices to your customers is not enough. Your business also has to collect the payments against them.
The payment collection depends on your business's collection model and your client's payment system (governed by the vetting of invoices, mode of payment, frequency of payment, etc.) These complexities may introduce delays in settling these invoices, which is where Days Sales Outstanding enters the picture.
Days Sales Outstanding calculates the average number of days taken to collect payments against credit sales. It is worth clarifying here that credit sales are sales that one settles at a future date after the product is delivered or service is rendered.
DSO calculation helps you identify the systemic procedural issues plaguing your business' cash flow. You can use it as a compass to carry out corrective action and streamline the collections process.
Given that DSO is a variable metric, it may also highlight certain trends surrounding your organization.
For example, higher DSO values signal that you are selling to customers who are less likely to settle their invoices. And even though such a practice may get your sales figures skyrocketing, it will have negative repercussions in the future. In contrast, lower DSO values allow businesses to collect more revenue, which is reinvested in the company’s growth.
On other occasions, a client may withhold payment for seemingly justifiable reasons, say, they are unhappy with the quality or the invoice is not adding up. In such instances, businesses must review their internal processes to address such problems.
While conducting an internal inquiry into the matter, it's essential to request payments for the undisputed sections of the invoice to keep the cash flowing.
Delayed accounts receivable may even be an indication that your collections process is inflexible or not very customer-friendly, which restricts their options. Accordingly, you may have to diversify your payment options to collect them on time.
On that note, the correlation between DSO and Cash Conversion Cycle (CCC) requires special mention. The CCC is a reflection of the monetary value generated for every dollar invested in the business. Therefore, it takes into account elements like the time taken to manufacture products, sell inventory, collect accounts receivable, and pay accounts payable. Naturally, DSO plays a key role in determining a holistic understanding of the CCC.
As a result, DSO and CCC work complementarily, with the former giving an overview of the collections process and the latter deconstructing the business processes at large.
Before diving into the Days Sales Outstanding formula, let’s briefly go over the key terminologies involved while making the calculation.
Now that you are acquainted with the jargon, let’s proceed with the DSO formula. Here’s what it looks like:
DSO = Average A/R / Total Credit Sales (Number of Days)
A low DSO value indicates that the company collects its account receivables frequently. Conversely, a high DSO corresponds to greater latency between credit sales and payment collection.
Let’s gain a more holistic understanding of the concept through a working example.
Yo-han Kim owns a business. His income sheet reflects USD 25,000 as accounts receivable (A/R) on April 1st, 2020. By May 1st, 2020, the amount shifts to USD 20,000. During this period, Yo-han also makes credit sales worth USD 45,000.
First, he calculates the average accounts receivable.
Average A/R = (20,000 + 25,000) / 2
= USD 22,500
As mentioned in the problem statement, the total credit sales for the period is USD 45,000.
Further, April has 30 days. Hence, the number of days is 30.
He then refers to the DSO formula:
DSO = Average A/R / Total Credit Sales (Number of Days)
And performs DSO calculation:
DSO = $22,500 / $45,000 (30)
At this rate, Yo-han figures out that for the given period, it takes him 15 days to collect credit sales.
So, what else can one extract from the DSO value? The next section examines its relevance.
According to the National Summary of Domestic Trade Receivables, DSO typically averages around 31-32, which is considered excellent. However, the value is subject to various factors, with the industry where the business operates playing one of the most crucial roles.
For instance, a DSO of 110 days could spell doom for food manufacturers, while it is the norm for the oil sector.
Hence, to gain a realistic perspective on your business through DSO, you need to consider the average expectations prevalent in your industry. As of 2020, here are the industry-wide averages of the Days Sales Outstanding that you can use as a benchmark:
In addition to these industry standards, you must also refer to your competitor’s DSO and the terms they employ to improve DSO.
If your DSO ratio needs some improvements, you can make a few minor changes to your collection process to pull it down to normal values. Here are a few tips to improve DSO:
Days Sales Outstanding is a crucial factor that may bear implications on your business’ growth. You must calculate DSO frequently and monitor the changes to know which way your business is heading. This small consideration can help you stay ahead of any potential roadblocks in your business’s growth!
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