The DSO, for a given company, is a measure of the average number of days that it takes a company to collect payment after a sale has been made. If you frequently use trade credit, it is a central indicator for assessing your ability to receive payments on time.
If you’re wondering how to calculate DSO, the DSO formula works as follows, for a given period:
DSO = (accounts receivables / total sales) * number of days
For example, over the month of January, Star Fresh Ltd has sold for £50,000 worth of goods, with £35,000 in accounts receivable on its balance sheet at the end of the month. Its DSO is: (35,000 / 50,000) * 31 = 22.3 days. It means that on average in January it took Star Fresh Ltd 22 days to collect payment after a sale had been made.
The DPO (Days Payable Outstanding) is your mirror indicator: it allows you to see how many days you take on average to pay your invoices.
DPO = (accounts payables / cost of goods sold) * number of days
For example, over the year 2019, Star Fresh has spent £280,000 worth of COGS, with £30,000 in accounts payables on its balance sheet at the end of the year. Its DSO is: (30,000 / 280,000) * 365 = 39.1 days. It means that on average in 2019 it took Star Fresh Ltd 39 days to pay its bills and invoices to its creditors (suppliers, vendors, etc.)
The DSO allows you to assess your ability to convert your trade receivables into cash. These, along with inventories, make up the main element of your working capital.
The higher your DSO, the greater your working capital, and the lesser your free cash flow.
To that effect, the DSO is a key indicator of the financial health of your company. And if it has deteriorated significantly in recent months, on a global scale, that is no coincidence.
Calculating your DSO is one thing. Knowing how to interpret it is another.
DSO improvement only makes sense in relation to your business strategy. In theory, a company or a sector that is accustomed to selling on credit will have a higher DSO.
As with working capital, the variation of the DSO from one period to another is what counts, more so than its absolute value.
Example 1: Company A is used to selling on credit on its domestic market – usually around 10 days – but is now expanding to a foreign country, with a large customer that turns out to take longer to pay the invoices – about a month. Company A’s average DSO is going to go up from 10 to 15 days.
Example 2: Company B has a loyal and regular customer base and usually allows a payment term of one month. For several months, its DSO has stabilised at roughly 30 days.
In this case, it is company A that must be particularly careful, despite a lower DSO: its ability to be paid on time, and therefore its free cash flow, has deteriorated. Company B however is aware of its average DSO and has anticipated it.
Financially speaking, it is always good to lower your DSO. However, it can be beneficial commercially to offer your clients an attractive trade credit policy, which will mechanically raise your DSO. To get tips on finding the sweet spot between protecting your financial situation and offering attractive terms, have a look at our article on how to negotiate payment terms.
The sectors with the highest DSOs are construction, electronics and machinery, at more than 80 days – compared to an overall average of 65 days (read our report on payment delays due to Covid-19 to learn more).
Before expanding to a new market, checking the country's average DSO in your sector is a good way to establish an adequate business strategy.
It is up to you to define your business strategy: the objective is to define a target DSO that is adapted to the reality of your business and your company.
To that effect, you can evaluate the following criteria:
- The creditworthiness of your clients: how well do you know them? What is their payment history with you or with other suppliers? To go further, read our article on how to assess your customers’ creditworthiness on our US website.
- Recent changes in your working capital: has it shot up in recent months? Can you afford to reduce your free cash flow? For more in-depth knowledge on cash flow, check out our ebook How to protect your cash flow.
Once your target DSO has been set, the goal is then to stick to it as best you can and review it regularly, especially when you enter work with new customers or a new market.
There are several ways for DSO improvement:
- Negotiate better payment terms: set up shorter payment terms, advance payments, early payment discounts…
- Strengthen your invoicing process: improving DSO often requires a focus on making sure that invoices are going out on time, contain all necessary information and are free of errors.
- Better manage accounts receivables: invest in efficient payment monitoring to remind customers of unpaid invoices, and define a clear recovery processes – if necessary through a debt collection agency.
Trade credit insurance remains one of the most efficient solutions to ensure the stability of your DSO. With trade credit insurance, you are insured in the event that a credit cannot be recovered. As a result, you are guaranteed that a potential bad debt will not have a negative impact on your working capital. Read our article on how credit insurance helps to secure your cash flow to learn more.
In conclusion, more than lowering your DSO, it is important that you keep it under control: a rising DSO is a sign that you are no longer in control of your invoicing and debt collection process and that your financial health is deteriorating. It is therefore important to constantly monitor it and work on improving it while maintaining good relations with customers.