Let’s face it, cash is king. As a business owner, you know it is in your best interest to collect outstanding receivables as quickly as possible. Quickly turning sales into cash allows you to put the cash to use again to reinvest and make more sales. So which accounting calculation is your friend in helping you see if you are being effective at bringing money in? DSO or Days Sales Outstanding is the most widely used measure of back office efficiency by credit executives.
Without boring you like Charlie Brown’s teacher, I will explain why knowing it can ultimately help you improve your cash flow in the future and, then, let’s get to the meat of how this little equation works.
Why do you care about DSO?
When used consistently, this calculation can help you answer a variety of questions such as:
- What is the effectiveness of my credit and collection policies?
- Are my credit terms in line with competitors? The Credit Research Foundation (CRF) does a quarterly study, the National Summary of Domestic Trade Receivables (a.k.a., the DSO Survey), that is an examination of the condition of AR for U.S. companies. The results of the complete study are available to CRF members and those participating in the survey.
- Are my collections procedures successful in meeting my goals?
- Is my customer base risky?
- What is the real reason for the changes within my receivable balance? Was it a fluctuation in sales during that period, or are promotional discounts, seasonality or selling terms making the impact?
Unleash the DSO.
Days Sales Outstanding expresses the average time, in days, it takes your company to convert its accounts receivables into cash. There are several ways to calculate DSO. Each method for calculating DSO (outlined below) has its own strengths, and each is based on what might be called the Standard DSO formula. The key to making effective use of any of these tools is consistency. Select the method s that work best for you and stick with them.
- The Standard DSO calculation provides an average (aggregate) time in days it takes to convert accounts receivables into cash. It should be tracked over time and compared to previous company results or industry/competitor benchmarks
DSO = (Ending Total Receivables / Total Credit Sales) x Number of Days in Period
- Best Possible DSO utilizes only your current (non-delinquent) receivables to calculate the best length of time you can achieve in turning over receivables. It should be compared to the standard calculation above, and be close to your terms of sale. The closer your standard DSO is to your best possible DSO, the closer your receivables are to your optimal level.
Best DSO = (Current Receivables / Total Credit Sales) x Number of Days
- True DSO calculates the actual number of days credit sales are unpaid by tracking individual invoices to the month of sale.
True DSO = (invoice amount / net credit sales for the month in which the sale occurred) x number of days from invoice date to reporting date
Of course, if your DSO shows it is time to reign in those receivables, there are several strategic ways to go about this. We’ll delve into that next week . . . to be continued . . .